Sometimes mass confusion presents investment opportunity. For shares of Nike Inc. (NKE), that’s the case right now.
The sportswear giant just announced its third quarter numbers (its fiscal year ends in May). They were pretty great. Yet, investors are selling off NKE in droves today.
During the company’s third quarter, it reportedly took in $9.6 billion in revenue – right what analysts expected. It also locked in a $0.68 net income per share. That actually beat analysts’ $0.65 target for the company.
So, why are investors selling off Nike today?
CEO Mark Parker told shareholders that the strong U.S. dollar is going to hit the company next quarter in a bad way. He also mentioned that the company’s North American sales were not as good as expected during the last quarter.
This gave investors pause as they reevaluated the last three months of share price movement. NKE has shot up 35% from its late December lows. That massive rally brought in all kinds of speculators and momentum traders. Now, with this tiny hint that the company isn’t perfect, they seem to be scattering.
Analysts, on the other hand, are taking the opposite opinion after this latest earnings announcement. Analysts from all over the place have been praising the company’s performance. Despite what investors think, Cowen analysts even called Nike’s execution “flawless.”
These same analysts have price targets for the company ranging from $87 all the way up to $100. They are currently trading at $83 after this sell off. Meaning all analysts seem to believe there’s room for this thing to grow.
But before you go out and buy shares of Nike, take caution. Shares were trading below $70 just a few months ago. If this fourth quarter is truly subpar, or if all those momentum traders have abandoned Nike, shares could fall back to that level.
That doesn’t mean there’s no good way to play NKE right now. In fact, that volatility gives us a great opportunity. But first, let’s take a look at just how choppy the stock has been of late.
As you can see, every few months shares have danced in a new direction… and quickly. The swing from $84 last fall to its December lows shaved off more than 20% of capitalization. Now, as noted, we’re seeing the potential end of a 35% rally to NKE’s all-time high.
It is a bit too early to tell, however, which direction it’ll move next. Those traders looking to piggyback on the company’s great near-term performance might indeed flee. So, shares could come back down to a more value position in the $75 range.
OR, long-term investors could use this slight post-earnings dip to load up on even more shares following analysts’ advice. If they believe $100 is the right price for Nike, $83 is cheap.
So, we just can’t know where Nike’s share price will end up over the next month or so. But we do know it’ll likely move in a large fashion.
And for options traders, that’s all they need to know.
A Strategy For Short Term Volatility
Traders looking to play an increase in volatility often use a strategy called a long straddle. A long straddle is a type of trade that involves buying both a call option and a put option.
It sounds strange. But it does work… more often than you might think. Both the put and the call need to have the same strike price and the same expiration for it to be a long straddle.
That means traders using this strategy are betting the stock will likely move in a large fashion one of the two directions.
It doesn’t matter which way shares head, either the call or the put will profit enough to cover the other’s cost.
You can see how that looks here:
Source: The Options Industry Council
As you can see, the only way for this trade to lose is if shares don’t move at all. But if they do move, the profits are nearly infinite.
Two ways to make a near limitless profit doesn’t come cheap however. The downside is that to open this trade you’d need to be willing to buy two options at full price — each with strike prices at the underlying stock’s current price. So, they aren’t cheap either.
But that risk is often worth it… especially for a company that is in prime position to make a major move like Nike.
Let’s look at a specific example, and you can judge for yourself…
A Specific Trade For NKE
As we said, shares of Nike are trading right at $83 after their large drop today. So, that’s the right strike price to use for a long straddle position.
To enter this trade, you could buy an April 18 $83 call for $2.17 per share and an April 18 $83 put for $1.95 per share. That works out to a $4.12 per share entry cost. Since each of these two options cover 100 shares of NKE, that’s a net debit of $412.
That may sound expensive. But consider that $412 wouldn’t even buy you five shares of Nike. And even if the analysts are right, and shares rise to $100… those five shares wouldn’t make much — about $88.
Instead of that, traders using a long straddle strategy could make much, much more. Despite absorbing the cost of the put in this scenario, the call would have an intrinsic value of $17 per share – or $1,700 in total. That’s a serious profit.
But as we noted above, it is just as likely for shares to crash back to where they were before. If that were to happen, the put would be the one with a sizable profit. In either case, this strategy wins big.
To find the point at which it does become profitable, take the entry cost and apply it to the strike price. So, if shares of Nike fall below $78.88 ($83 – $4.12 = $78.88), the put will be profitable enough to cover the total entry cost. Likewise, if shares rise above $87.12 ($83 + $4.12 = $87.12), the call will make the whole trade profitable.
A move like that in one direction or the other is very likely considering the confusion investors are facing today. This strategy plays on that confusion perfectly.
— The Option Specialist