A Trade for a Weak Black Friday

Brace yourself. The time of year for holiday sales fliers is here. Next week will bring both Thanksgiving and the mania that is Black Friday.

As we head into the most important week in retailers’ year, let’s consider just how the industry has done so far in 2018:

11-15-18 chart.gif

As you can see, despite a rough October, retail (represented by the SPDR S&P Retail ETF in black) has outperformed the market (represented by the S&P 500 in gold). That may seem strange considering what all has happened in 2018 — tariff wars, transportation cost increases and the ever-increasing threat from the likes of Amazon.

But to understand exactly how this sector will perform during this crucial period, you need to look at how individual companies within it are preparing.

One strong indicator that 2018 won’t replicate 2017’s unexpected Black Friday success is store closures. About 5,000 total retail stores have closed in the U.S. so far this year. While on par with 2017’s numbers, we haven’t yet seen the full brunt of closures.

Sears filed for Chapter 11 bankruptcy last month. Its stores and its subsidiary, Kmart, will suffer increasing closures throughout the rest of the year… right in the teeth of the shopping season.

While the impact on Toys R Us’ bankruptcy has already been felt, it can’t be ignored when discussing this subject. The former toy store behemoth closed nearly 900 stores just this year. Walgreens dropped 600 stores.

You can’t outperform previous sales when you don’t even have the stores to sell product. That fact is going to hit the industry hard in 2018.

But there are plenty of other reasons to remain suspicious of retail entering into shopping season beyond store closures.

As noted above, transportation costs have risen this year. The impact of this can’t be understated. While brick-and-mortar stores continue to lag e-commerce, shipping becomes a more worrisome problem.

You’d think e-commerce would be just as affected. But with Amazon’s vast and growing network of mega-warehouses, it can control its shipping costs much more than retailers without them.

This is one trend that has already affected Black Friday preparation. Last year’s performance was based on smooth inventory levels. With the increase in tariffs and transport costs, retailers have had to make uncomfortable choices when it comes to pre-shopping season inventory.

At the low-priced store side, many companies have increased inventory as to be prepared for further cost increases. That could backfire and accelerate any negative sales during this crucial week.

As for global brands and higher-end retailers, many are keeping low product levels. So, even if consumers are ready to spend, they might not be able to. And you know what would happen if they are turned away from a store. They’ll simply go online and buy from competitors.

Now, none of this means retail is dead just yet… or that this is going to be the ugliest Black Friday in history. Likely, it won’t be terrible. Consumer confidence remains high entering this crucial season.

So, how does one play a trend like this… likely short-term weakness, with the potential for an upside surprise?

A Trade to Profit on Short-Term Weakness

One strategy that plays well with short-term weakness is to use a bear call spread. This kind of trade results in a net credit to the trader’s account.

The idea behind this type of play is to max out your profit potential right at the start of the trade. If the underlying stock doesn’t move any higher, or even falls from its current level, you get to keep that credit you received to open the trade. And if shares decline before it nears expiration, you will be able to close out your trade earlier.

The downside, however, is if shares of the underlying company rise before expiration. The trade then results in a loss. But it is limited. Therefore, it is seen as safer than simply shorting the underlying company’s shares.

To enter a bear call spread, you would need to sell a call option with a strike price near the stock’s current price and buy a higher call option with the same expiration. This results in a net credit (the premium for the call sold minus the premium from the call bought).

The total risk is the difference in strike prices between the two options minus the credit received when opening the trade.

The maximum profit potential is found if the stock simply does nothing or goes lower. Here’s a graph showing how that looks:

bearcallspread.jpg

Source: The Options Industry Council

A Specific Bearish Trade on XRT

XRT is a great gauge of the retail landscape in the U.S. Its holdings include a wide range of retailers like L Brands (parent of Victoria’s Secret and Bath & Body Works), Walgreens and Sally Beauty Holdings. We already discussed the weakness at Walgreens. But there are plenty more on this list set to have a bad holiday season.

The beauty of using this ETF as the focal point for a bear call spread trade on retail is because of its makeup. While certain retailers will undoubtedly do better than expected on Black Friday, you can be sure that others will hold this ETF back from rallying too much. For this strategy, that’s exactly what you’d want.

Possibly even more important than that, XRT doesn’t hold Amazon shares. So, even if the e-commerce giant does something earth-shattering performance-wise during this crucial week, it won’t affect the ETF.

To enter a bear call spread on XRT, you could sell a December 21 $47 call for $1.21 and buy a December 21 $48 call for $0.80. That would give you a net credit of $0.41 per share, or $41 since each option is worth 100 shares.

That’s your total profit potential. If shares of XRT do nothing from here or even fall as is quite possible if the sector underperforms last year, you keep that credit.

If, however, shares do rise, your sold call will start costing you money. The most you can lose, however, is bound by that upper call.

To find the total risk with this trade, you simply find the difference in strike prices between the calls ($48 – $47 = $1) and subtract the credit you received to open it. That works out to a total risk of just $0.59 per share, or $59 per contract.

That means this particular bear call spread trade on XRT offers a potential return of 69.5% of the amount risked.

As you can see, your risks are limited if Black Friday really does end up just as good as last year. But you still would profit from any negative sales results.

— The Option Specialist

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About the Author: The Option Specialist