Trades

378% Profit Potential From Pepsi’s Lackluster Quarter

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This morning PepsiCo (PEP) announced its second quarter earnings. The soda giant handily beat analyst estimates for both top and bottom lines. Yet, investors remain unimpressed.

The company has been struggling for a while now as fewer and fewer customers are buying its sugary drinks. That’s a problem that isn’t going away despite a single decent quarter.

The company’s CFO announced that while volumes remain in decline, the company has been able to increase pricing to get the soda segment back into growth mode of around 3%. Investors, however, seem to only be focusing, today at least, on those volume numbers.

Shares are down 1.1% as we write. But considering the company’s solid earnings and revenue beat for the quarter, that’s discouraging. For the past week and month Pepsi has been flat to down. But if you go back further, you can see why investors might not be willing to drive prices up from here:

Screen Shot 2019-07-09 at 4.51.49 PM.png

As you can see, 2019 has been very good for PEP shareholders. That’s a trend the could easily breakdown considering the initial reaction to this earnings season.

The growth for the quarter, or at least the better than expected numbers, were driven from not Pepsi’s soda business… nor its sports drink segment… but its snacks.

Its Frito Lays group, which sells Doritos, Cheetos and all other sorts of snack foods, saw great growth despite consumer habits veering away from these products overall.

All of this sounds fine. And considering the state of the company’s restructuring and recent marketing efforts, it is. But it has serious questions to answer going forward.

For instance, the market for sports and energy drinks continue to be flooded with competition. Athletes now favor labels like BODYARMOR over Gatorade (Pepsi’s brand). How will it deal with this fast-receding moat around sports drinks?

Its Quaker Oats group faces shrinking margins and flat sales – a bad combination. How will it regain market share and keep margins up in a dying segment?

These questions are being posed all across the industry. But for Pepsi, investors are demanding answers now.

Surprisingly, shares didn’t move more today following the company’s announcement. But this relatively low volume response to a major quarterly report like this one won’t last long.

You see, PepsiCo was just the first of these companies to report its first half earnings. The likes of Coca-Cola and Nestle report later this month. Investors are waiting to see how Pepsi stacks up against them before making a move.

The investment community continues to flirt with “risk-off” investments as uncertainty over what the general economic picture will look like in the second half of this year. Pepsi, Coke and other competitors are very much part of that picture. So, major movement is coming for these stocks. But the direction is less certain.

Fortunately, there’s a way to trade movement without needing to pick its direction. For options traders, there’s a strategy for that…

A Strategy For Short Term Volatility

A long straddle is a type of options trade that involves buying both a call option and a put option with the same strike price and expiration date on the same underlying security.

It sounds counterintuitive to place both a long and a short bet on the same stock. But that’s also why it works so well.

You see, you don’t have to know ahead of time if the stock will rally or collapse. In either case, one of the two options will increase in value. The trade becomes profitable when one of those increases outweigh the cost to get into the trade.

You can see how this kind of trade plays out here:

longstraddle

Source: The Options Industry Council

As you can see, the risk is known right up front. It is found by simply adding up the cost of both legs of the trade. That upfront cost is also the only amount at risk for the duration of the trade.

That does make this strategy a bit more expensive to get into. But it also presents the best possible profit opportunity.

While the cost is limited, the maximum potential profit isn’t. If shares skyrocket, the call soars in price. If shares plummet, the put does. In either case, the further from the strike price the underlying shares head, the greater the trader’s profit.

Let’s look at a specific example for PEP, considering a major move is coming as earnings season continues on…

A Specific Trade in PEP

Right now, a trader could buy an August 16 $130 call on PEP for $3.35 per share and an August 16 $130 put for $1.88 per share for a total cost of $5.23 per share. Since each represent 100 shares of PEP, that’s a total cost of $523.

Now, that may seem expensive. But it really isn’t. That’s the total risk of this trade… that’s true. But for the trader to lose this whole amount, shares of Pepsi would have to stay absolutely still for the next five and a half weeks. Considering all the turmoil and upcoming scrutiny of its industry over this time period, that’s nearly impossible.

And as noted, the reward for this large upfront cost is unlimited profits. For instance, if shares of PepsiCo return to just where they were at the start of the year, the trader would be looking at a payout of $1,977. That’s a 378% return on the amount at risk.

Now, I’m not saying that’s definitely going to happen. But consider how easy it is for this play to at least venture into profit territory.

To find the profit inflection points, compare the cost to the strike price. If shares rally, the call will become profitable at $135.23 ($130 + $5.23). Likewise, if shares fall, this trade returns a profit as shares slide below $124.77 ($130 – $5.23).

In either case, that represents a move of just 4% from the strike price. To put that in perspective, shares of Pepsi are up 25% year to date. That’s a monthly movement right above 4% or so.

Considering the incredibly important upcoming events – especially the Fed’s decision later this month and Coca-Cola’s earnings – we should see that monthly movement double or even triple.

Again, Pepsi doesn’t have to break any records for this trade to turn into a tidy profit. Just a slight movement would put cash in the trader’s pocket… and it doesn’t even matter which direction that movement takes.

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