Trades

255% Profit Potential With This Walmart Trade

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Despite margin squeezes from global tariffs, increased online competition and extended overvaluations, Walmart Inc. (WMT) has been an absolute stock market darling over the last several months:

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Earlier this month, the company hit yet another all-time high. This seems to fly in the face of what a rational person might think should be the case.

Amazon has been called an industry killer, retail disrupter and king breaker. When you hear headlines like that, you might think they’re talking about Walmart being killed, disrupted or broken. But you’d be wrong.


If you have been following this company for the past few years, you know the real story. Amazon has indeed broken plenty of companies — think Toys R Us. But Walmart has not only kept up, but done better than ever facing this game changing competition.

The brick and mortar giant is seeing incredible growth from its ecommerce efforts. In the last quarter alone, Walmart recorded a 37% growth rate in online sales. When you think of Walmart, you probably don’t assume it can grow anything by 37% in a single quarter. But here we are.

It is keeping up with Amazon’s amazing domination online. Either name recognition, the online order and in-store pickup or its sizable footprint in grocery sales can be the reason for its success. Likely, it’s all three. But whatever the reason, Walmart isn’t down and out. Its all-time high stock price can attest to that.

Clearly, investors have liked what they’ve seen the past several quarters. But this next one could be a true test unlike those previous ones.

You see, even analysts are expecting a somewhat weaker performance. They are calling for earnings per share of $1.22 for the company’s second quarter, which will be reported on August 15. That compares to year-ago EPS of $1.29.

Now, Walmart could surprise them. In fact, that’s likely and the very reason why its stock has done so well. It has decimated estimates quarter after quarter in a serious of earnings beats.

But it might not matter this time. Just seeing a dip in earnings could be enough for investors to finally take their foot off the gas pedal. You see, the company has done well. But its stock has done too well in comparison.

Right now, the company is trading at 23 times its adjusted trailing 12 months of earnings. To put that in perspective, its main competitors trade at just 14 times their earnings. Target, its closest like competitor has a price to earnings ratio of just 15.5. Meaning, Walmart is significantly overpriced right now… and has been.

So, if Walmart does have a weak quarter as expected, that would only push this valuation higher. As the denominator of the P/E formula shrinks, the end number goes up. For investors, Walmart stock is a slow growth and steady dividend type investment. They should shy away from any spike in valuation.

Basically, all of this just means that after its next earnings announcement in the middle of next month, shares of Walmart should correct… even if just a little bit.

The June rally was clearly a bit too much. July was relatively flat, but there’s still room to fall, as you can see here:

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So, a price target of $105 is definitely not out of the question. The only thing left to consider, however, is how to play it.

Fortunately, there’s a strategy that lets traders get in a falling share prices, but don’t break the bank like shorting them would.

A Strategy For Short Term Bears

A bear put spread is a type of options trade that involves buying one put and selling a second one with a lower strike price. The reason for this is to profit from the long put as shares slide lower, while also reducing the amount at risk by the income received from the short put.

You can see how this kind of trade works here:

bearputspread

Source: The Options Industry Council

As you can see, the sold put acts as a kind of check on both risk and profits. The income received by selling that put reduces the cost of the trade, which therefore reduces the risk of the trade. However, it does cap the amount of profit that can be made. For a stock like Walmart, that’s actually a great trade off.

You see, Walmart is doing well. Yes, it is due for a correction. But it isn’t likely to collapse overnight. With it trading at $111.69 as I write, a fall to $105 wouldn’t break the bank. And for short sellers, it wouldn’t even be worth the effort.

But for traders using this strategy, it could turn into a nice chunk of change.

Let’s look at a specific example to show you just how much…


A Specific Trade on WMT’s Q2

Right now, a trader could buy a September 20 $110 put for $2.65 per share and sell a September 20 $105 put for $1.24 for a net debit of $1.41. Since each put is worth 100 shares of WMT, that’s a total cost of $141.

That $141 is the total amount at risk for the full duration of this trade. If the company does outperform again and investors continue to turn a blind eye on its overvaluation, that’s how much this trade would lose.

However, if shares come down even a slight bit following next month’s all-important earnings announcement, the potential profit is even higher.

To find that, take the difference in strike prices ($110 – $105 = $5), and subtract the cost ($5 – $1.41 = $3.59). On 100 shares, that’s a maximum profit potential of $359.

In other words, the trader would be looking at a return on risk of 255%. That’s a huge return considering shares of Walmart would only have to slip from $111.69 to $105, or 6%.

In June alone, they rose 9%. A retraction of 6% would be nothing to investors looking to take a little profit at this point.

So, as you can see, the risk of the trade is well worth the potential reward. And it won’t take a whole lot to max out the gains on this one. Even if investors don’t immediately realize just how overvalued WMT is post earnings, this trade builds in a full month extra to compensate.

In any event, this is the best way to play the inevitable profit taking correction Walmart is long overdue.

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