Grab a Band-Aid If You Miss This 70.3% Potential Return

There are certain words and phrases you see in finance and investing that are so overused they have become tropes or clichés. One, which I’m certainly guilty of using in the past, is “a perfect storm.”

In fact, a google search reveals that “perfect storm ‘market’” comes back with about 190 million results and “perfect storm ‘invest’” returns 16.2 million results. That’s one big storm!

The meaning is obvious. Whenever certain events conspire to give an investor a tremendous investment opportunity that ordinarily wouldn’t be there, we use that phrase. But sometimes, it’s important to step back and consider just how extraordinary regular or “pretty good storms” can be for profit opportunities.

It’s easy to assume that if you can take your emotions out of investing, you’d do better. There’s plenty of research to back that idea up that emotions often influence poor investment decisions. But sometimes, if you follow the markets close enough, you can see others making too much of emotions. Now is one of those times.

The tide has turned a bit over the last six months in the market. While it was climbing higher and higher over the last decade, investors rewarded companies that beat analyst expectations for their top and bottom lines with increasing share prices. Earnings season, for the better part of that entire 10-year period, came down to basically one number, earnings per share.

That’s changed since the market corrected last fall. Now, you see headlines about how the trade war with China is really affecting various companies, the government shutdown with no end in sight and the lowest consumer confidence levels of the Trump Administration. With that in mind, you can see what emotions investors are bearing while looking at earnings reporting.

Instead of how have you performed, the focus is now on how will you perform with these economic headwinds? The latest victim of this turn in investor perspective is Johnson & Johnson (JNJ).

J&J is one of the largest multinational companies in the world. It has its hand in everything from pharmaceuticals to baby powder (not a popular product right now, unfortunately for the company). Therefore, it is one of the most scrutinized by investors and the financial media.

That’s why it shouldn’t come as any surprise that despite beating both top- and bottom-line analyst estimates this past quarter, the company’s shares are down today on “slower growth forecasts.”

On the surface, that type of post-earnings movement sounds certainly reasonable, right? Well, there are several more reasons why this take is not only wrong but sets up a “pretty good storm” for bullish investors. And it could set up a tremendous return on risk trade.

Johnson & Johnson’s Headwinds

Johnson & Johnson is on the hot seat over a few things right now. First, it is battling court cases surrounding the safety of the potential talcum powder of its most recognizable product, J&J baby powder. It has been linked in studies to about ovarian cancer in women using the product. These cases continue to weigh on the company. Many are reminded of the Tylenol tampering lawsuits of the 1980s.

Certainly, this is not good for J&J. The company continues to fight these cases. And there’s no indication yet of how it will all play out. But even if every court rules against the company, baby powder is just one of thousands of brands at the company. And even if the payouts end up in the billions of dollars, the company has more than $16 billion in cash on hand and the best credit rating in the world. The company isn’t going anywhere.

Of course, this is not really the reason investors are selling shares of JNJ today. The company announced earnings. And despite beating estimates of both its revenue and earnings per share, it signaled some slowing growth for a few of its product lines.

One area of concern, at least for investors, is generic drug competition for some of its pharmaceutical portfolio. To go into each individual drug would take forever. But suffice it to say, the company has plenty in the pipeline to deal with expiring patents in both the short and long term. Investors, however, are somewhat focused on the government shutdown, and therefore a freeze on FDA approvals, delaying new J&J drugs coming to market.

While a short-term concern, it matters little to a company so large. And because of the shutdown, no one seems to be talking about the fact that that generic competition is going to be slow to come to market as well.

The second area CFO Joseph Wolk disappointed investors this earnings season is on the company’s largest asset, its global reach. The company operates around the world. So, with a strong dollar, it actually loses on the currency exchange front. Wolk indicated the quarterly loss was around $1.2 billion because of the strong dollar.

That, however, is likely to reverse this year as Fed rate increases slow and the government continues to remain dysfunctional in the U.S.

All of this results in a near “perfect storm” for contrarian investors. You see, because of the downward pressure and overall market fluctuations, J&J’s stock is trading at very low levels. In fact, right now, shares of JNJ are priced lower than they were last summer. The company’s performance, and expected performance is better than these prices reflect.

There’s plenty of obvious ways to play a short-term bounce in the event investors take note of the actual facts surrounding JNJ. But only one offers such a low-risk, high-reward potential outcome.

A Strategy For Short Term Bulls

A bull call spread is a type of trade we often discuss here. It involves two call options. A bullish trader could buy an at-the-money or near-the-money call option on a stock and sell a second call with a higher strike price.

The effect of this trade is a net debit, as the cost of the bought call is higher than the sold one. But that second call significantly lowers the amount of money at risk.

The result is a small, limited amount of money at risk and a set and easily achievable maximum profit potential if the underlying stock does go up.

Here’s how that looks:

image1

Source: The Options Industry Council

Let’s look at a specific bull call spread on JNJ. This one is one of the best examples of how lucrative they can be even in a “pretty good storm” situation.

A Specific Trade For J&J’s “Pretty Good Storm”

A trader looking to use a bull call spread trade to profit from J&J’s current situation could buy a February 15 $128 call for $2.33 per share and sell a February 15 $129 call for $1.96 per share for a net debit of $0.37 per share. Since each represents 100 shares, this trade would total $37 in entry costs plus commissions.

That $37 is the total amount the trader would have at risk for the duration of this trade (about four weeks).

To find his potential return, take the difference in strike prices ($129 – $128 = $1) and subtract the entry cost ($1 – $0.37 = $0.63)… or $63.

That means, his return if shares of JNJ rise above $129 per share, which is still lower than they were trading yesterday, would be 70.3% on the amount at risk.

As investors fully take in how great of a quarter and full year J&J just had, that jump to above $129 is very achievable.

— The Option Specialist

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About the Author: The Option Specialist