Options Corner: Why The Trade-Down Effect Could Power A Reversal For Kroger

At a cursory glance, grocery giant Kroger Co KR doesn't seem to offer an appetizing thesis. Since early May, KR stock has struggled for traction amid a difficult economic environment. Still, Kroger fundamentally benefits as one of the ideally positioned enterprises regarding the trade-down effect. Subsequently, management has an opportunity to reaffirm this message with this coming Friday's earnings disclosure.

If it's any indication, Wall Street seems generally optimistic about the grocer. As a consensus, analysts expect Kroger to report quarterly earnings of $1.46 per share, up from $1.43 in the year-ago period. Per data from Benzinga Pro, covering experts also anticipate a modest increase in revenue to $45.31 billion, up from $45.27 billion one year ago.

Adding to the quiet enthusiasm for the company, Evercore ISI Group recently maintained its Outperform rating on KR stock. Overall, analysts are in wait-and-see mode, with a 3.1 consensus rating out of 5.

While it's always difficult to predict the market's response to earnings results, the key fundamental catalyst that Kroger enjoys is the trade-down effect. As the Chicago Booth Review wrote, "[w]hen times are tough, consumers have the option either to buy less of a product or to buy cheaper versions of it."

In Kroger's case, this phenomenon should be a net positive. When financial pressures weigh down on individuals, one of the easiest budget items to cut are discretionary items, such as going out to eat. Since humans still require nutrients irrespective of economic conditions, Kroger should be able to soak up the money that would have gone elsewhere.

Plus, if the trade-down effect positively impacted last quarter's numbers, management will have a strong narrative to share with investors. That's a fundamental reason why KR stock might break out of its current slump.

Statistical Backdrop Points To Potential Recovery In KR Stock

Although some of the storylines that support the bullish case for KR stock seem credible, narratives can be imprecise in terms of timing. But because investors tend to think in long-term frameworks, this imprecision isn't the biggest problem in the world. When analysts issue their 12-month price targets, the length of time affords a lot of flex for the thesis to pan out.

On the other end of the scale, trading (especially options) trading is a different animal altogether. Rather than focusing on the "why" of an investment, traders zero in on the "how" — how much, how fast, and most importantly, how likely. Stated differently, options trading, because of the underlying expiration date, centers on probabilities because the thesis must be accurate in magnitude (y-axis) and in time (x-axis).

In most practical applications, there are two categories of probabilities: derivative and conditional. The former calculates the odds of an outcome materializing across the entire distribution of the dataset. The latter conducts a similar calculation but for a specific subset within the data.

To use a baseball analogy, derivative probabilities are akin to a player's batting average over a whole season. Conditional probabilities represent situational batting averages, such as when there are runners in scoring position (RISP). Naturally, conditional probabilities are more useful for traders.

However, finance is a tricky beast because the standard measurement metrics — such as share price or earnings-based valuation ratios — are non-stationary; in other words, they change over time and context. Calculating conditional probabilities requires stationary measurement metrics, which is why compressing price action into market breadth sequences of accumulative and distributive sessions is necessary.

Following such compression, the current demand profile of KR stock can be expressed as 3-7-D: three up weeks, seven down weeks, with a net negative trajectory across the 10-week period. While the balance of distributive sessions greatly outnumbers accumulative sessions, this sequence historically signals a reversal. In 65% of cases, the following week's price action results in upside, with a median return of 2.68%.

Depending on how the actual nuances shake out, KR stock could be on course to land between $67.80 to $68 in short order, perhaps a week or two.

An Aggressive Bull Spread For The Checkout Lane

For those willing to roll the dice on a positive earnings result, the 65/68 bull call spread expiring July 3 delivers an intriguing risk-reward profile. This transaction involves buying the $65 call and simultaneously selling the $68 call, for a net debit paid of $149. Should KR stock rise through the short strike price ($68) at expiration, the maximum reward is $151, a payout of over 101%. Also, at time of writing, the breakeven price is $66.49.

What makes this trade tempting is the implied shift in sentiment regime. As a baseline, the chance that a long position in KR stock will be profitable over any given week is only 50.82%. However, the statistical response to the 3-7-D sequence creates a favorable matchup. If this were a ballgame, the manager would give the batter the go-ahead to swing.

To be sure, this doesn't guarantee a positive outcome. But from the context of binary market demand sequences, there's a solid chance of a reversal. Thus, speculators have an incentive to consider a bullish strategy.

The opinions and views expressed in this content are those of the individual author and do not necessarily reflect the views of Benzinga. Benzinga is not responsible for the accuracy or reliability of any information provided herein. This content is for informational purposes only and should not be misconstrued as investment advice or a recommendation to buy or sell any security. Readers are asked not to rely on the opinions or information herein, and encouraged to do their own due diligence before making investing decisions.

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