A weak economic picture, market uncertainty, “recession”-plagued headlines and mixed Fed responses should send stocks into the kind of volatility we’ve seen.
However, those things should also send recession-resistant stocks higher… or at least stable and insulated from said volatility. But this isn’t your father’s recession… or uncertain economy… or geopolitical gameboard.
All of those volatility-infusing macroeconomic elements are accompanied by something new… the Trump trade wars.
Seemingly, no one is immune from that. Companies that should be handily beating the market aren’t. I’m not saying they are suffering… or doing worse. But companies like Walmart and Procter & Gamble are even feeling this trade war affecting margins.
So, imagine what it is doing to companies that rely on even cheaper products. Those 99 cent stores, Family Dollars and Big Lots are facing margin squeezes right when they should be exceling.
Of course, if excrement does indeed hit the fan, even the slimmest of margins could still make these kinds of companies the traditional recession-resistant plays they ought to be. But until then, the economy is doing just good enough and the trade war is just pesky enough to be seriously messing with these discount retailers.
It’s not like retail has been a friendly environment anyway. But now that these companies are feeling a squeeze in the period, they should be doing well is disappointing investors.
As for specifics, this mainly affects the two top dogs, Dollar General (DG) and Dollar Tree (DLTR).
Each control thousands of stores across the U.S. Now, to be fair, they aren’t both hurting equally. Dollar General is actually putting together a pretty solid year, truth told. Sales and earnings both jumped in the first quarter sending shares up through mid-July. Recently, they’ve been a bit rockier.
Dollar Tree, however, hasn’t fared so well. DLTR sales did rise in the first quarter of the year. But because of poor performance of its relatively recently acquired Family Dollar stores, the company’s bottom line sank. It also claims to have an even greater reliance on Chinese goods, meaning those tariffs have already been eating into its margins too.
This is where today’s opportunity comes in. While President Trump did delay its most recent round of Chinese tariffs until Christmas, Dollar Tree has clearly already been feeling the pain. It’s large move to buyout Family Dollar’s massive 8,000 stores has caused nothing but headaches.
According to the company’s own management, the stores needed a lot of work. Already the new parent (DLTR) has had to shutter hundreds of Family Dollars. The rest are undergoing a major makeover… one during a huge margin squeeze.
This combination, tight margins from the tariffs and a major capital expenditure plan to bring Family Dollar back into the black, makes this a perfect time to bet against Dollar Tree. To top it off, the company reports earnings next week, and it will only refocus upset, underperforming investors on DLTR’s weak financial situation.
Of course, simply shorting the company is a sucker’s bet. After all, if the economic picture does worsen in a hurry – after say, something the Fed does, Trump tweets or China retaliates – you probably don’t want to be shorting a discount retailer like Dollar Tree. Even if margins are shrinking, a real recession could drive enough sales growth to cover it.
Instead, we have a better way to play Dollar Tree’s more immediate problems…
A Strategy For Short Term Bears
A bear put is a type of options trade that involves buying a put option on a stock you believe is set to fall in the short term, and selling a second put with a lower strike price. This helps offset the cost of the first one, thereby reducing your total risk.
This risk reduction does come at a cost, however. The sold put caps how much potential profit you can make with the trade. If shares collapse in a bigger than expected way, some of the profits from your long put will be traded away.
You can see how this works here:
Source: The Options Industry Council
That’s not necessarily a bad thing, however. The tradeoff between reducing risk and capping potential profits makes a lot of sense in certain scenarios… like DLTR right now, for instance.
You see, Dollar Tree is going through a tough time with its renovations of Family Dollar and tariffs squeezing margins. But it is making efforts to stems some of those problems.
Its largest initiative is actually raising prices for the first time. Many items are no long $1 in its several thousands of stores. That could pay off for the company if customers don’t flee. And they likely won’t, even if they don’t like the new price structure.
So, a completely collapse, even if the company severely disappoints during its second quarter, is unlikely. Another dip, for sure. But this isn’t a play that’s likely to suffer a huge fall.
In this case, the reduction of cost more than makes up for the unlikely scenario that DLTR completely falls apart.
Let’s look at a specific trade to show you how this kind of trade might work out on Dollar Tree shares right now.
A Specific Trade on DLTR
Right now, a trader can buy a September 20 $97.50 put on DLTR for $4.40 per share and sell a September 20 $92.50 put for $2.30 for a net debit of $2.10 per share. Since each contract represents 100 shares of DLTR, that’s a total cost of $210.
That’s the total amount it costs to enter this trade and the total amount of risk if shares somehow skyrocket over the next month.
But considering how nervous investors are concerning Dollar Tree’s weakening margins and poor earnings, it’s far more likely we’ll see shares dip from here. If so, the payout is even better for this trade.
To find that maximum potential profit, take the difference in strike prices ($97.50 – $92.50 = $5), and subtract the cost ($5 – $2.10 = $2.90). Based on the 100 shares of each option, that’s a return of $290 in one-month’s time.
In other words, this trader is looking at a 138% return on the amount he has at risk… as long as Dollar Tree continues dipping.
Since the company has just a week before its next earnings call, the chance of it turning things around in time are slim. This could be a quick chance for traders to double their money with very little work.