Moms and Dads, get your shopping lists ready! Wal-Mart Stores WMT announced this week that it is dropping its prices on toys to get a jump on the holiday shopping season and potentially gain an edge over competitors such as Target TGT.
The world's largest retailer is lowering the price of popular toys, expanded its overall toy selection, and aggressively marketing these new prices through a 52-page newspaper circular. Everyone loves cheap toys, right? Except for those who feel price cuts could equal margin cuts.
There are bullish and bearish arguments to be made on WMT, which is why we've outlined two option strategies (one bullish, one bearish) for your reference below. These strategies are for educational purposes only; you should consider your personal goals, risk tolerance, and trading experience before considering any new trades. All prices are as of Wednesday's close, when WMT shares were at $54.51, down 54 cents on the day.
Moderately Bullish Option Strategy: Covered Straddle
Several weeks ago, we discussed a hypothetical covered strangle in Wal-Mart which is in profitable territory up to this point as the stock has edged moderately higher while time decay has eroded the value of the short options. (The bear put spread, however, is not profitable currently). For a different take on the covered strangle strategy, let's look at a covered straddle, which combines long stock with a short straddle.
Selling the December 55 straddle (shorting both the call and the put simultaneously) yields a net credit of $2.25. To “cover” this straddle, 100 shares would need to be bought. For illustrative purposes, assume the stock would be purchased at $54.88. If the stock is trading above the 55 strike at expiration, the stock will be called away to fulfill the short call and the straddle seller will keep the $2.25 straddle credit, the 12-cent gain in the stock, and potentially the 30-1/4-cent dividend. That's a return of nearly 4.5% in one month.
These gains begin to decline below the 55 strike through the breakeven price. Breakeven is the purchase price of the underlying plus the strike price – $109.88 – less the net credit ($2.25), divided by two or $53.815.
Risk, while significant, is contained at the zero mark. Below the 55 strike, the position is long 200 deltas due to the long stock and the short put. Investors should only put on this type of trade if they are willing to purchase more WMT shares at the $55 price level.
This is a complex strategy. To experiment with different prices, strikes, or expiration months, I would suggest using a profit/loss calculator tool such as the one in our virtual trading account.
Bearish Option Strategy: Ratio Put Spread
Wal-Mart bears could consider a put ratio spread, built by shorting two out-of-the-money 50 puts and going long one near-the-money 55 put. This trade could hypothetically be made for a net debit of 98 cents.
At expiration, the maximum potential profit is $4.02 (the difference in strikes less the premium paid) if Wal-Mart is trading right at the short strike (50) at expiration. Breakeven to the downside is $45.98 (short strike less the maximum profit) and breakeven to the upside is $54.02 (long strike minus the premium paid).
This trade offers a limited downside hedge of more than 15% to $45.98. What's more, this strategy is almost 25% less than buying a long put outright.
If Wal-Mart is trading above 55 when the options expire, the maximum upside risk is capped at the 98-cent premium paid. Downside risk is more substantial because of the uncovered short put that is in-the-money below the 50 strike. If WMT moves sharply lower, losses would be in line with a long stock position.
Photo Credit: D'Arcy Norman
The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.
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