Trades

Profit 247% With This Wal-Mart Trade

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Earlier this month, Walmart Inc. (WMT) announced its first quarter of earnings for the year. Investors were pleasantly surprised with better than expected earnings. But that’s the problem.

You see, Walmart has been under the gun regarding the trade war between the U.S. and China. So many of its goods come from overseas, investors are worried about squeezed margins due to increased tariffs… at least they should be.

In truth, Walmart trades on analyst expectations. Almost every quarter, the company beats analyst expectations… and its stock jumps on the news. But when analysts keep extremely conservative forecasts, that’s not too difficult.

What this has done is push Walmart’s share price well past the point at which it should be trading despite relatively flat earnings.

Just consider its historical price-to-earnings ratio:

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As you can see, something is going well off the rails this year. And there’s good reason to believe that its how the market is perceiving Walmart’s actual performance.

Don’t get us wrong, Walmart is still a strong company. It has done just about everything right regarding its online presence, handling competition from Amazon and holding as tight as it can to its margins. The problem, however, is out of its hands.

Just over the last few days, China has announced it will stop buying soybeans from the U.S. and is considering restricting rare earth metals from U.S. technology companies. Neither of these play a direct role in Walmart’s bottom line. But it does show that the tariff trading between the two countries is far from over.

Walmart should actually be reeling harder from this problem than the rest of the market as a whole. It is so intertwined with China that there’s no way for the company to avoid further margin cuts.

Yet, despite that, Walmart has outperformed the S&P 500 in the month of May (as the rest of the market dropped due to this very trade war problem) by a whole five percentage points. That’s a large break from how it used to trade.

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In its most recent quarterly financial release, the company somehow combed over the fact that it saw both income and cash flow fall despite higher revenues. In other words, its margins are contracting faster than it can keep up with.

This presents us with a significant short-term opportunity. Considering it is unwise to bet against the company during its earnings season, we should instead do that between earnings seasons.

The recent outperformance of the rest of the market was due to its most recent earnings. So, for the stock to realign prior to the next one, it’ll have to come down in price. This gives us a window of opportunity. And there’s a perfect way to play that.

A Strategy For Short Term Bears

A bear put spread is a type of options trade that involves buying one put option and selling a second one with a lower strike price. It sounds strange, but it does make sense.

The reason this works is because if you have a falling stock, and buy a put option, you profit off that fall. The second put option – the one you sell – lets you collect a premium that helps offset the cost of the first one.

If shares completely collapse, this sold put would limit how much you stand to profit, as the maximum profit potential is capped by the strike price of that put. But for a stock like Walmart, there’s little chance of a complete short-term melt down.

The stock should remain weak for the next few weeks and is likely to fall. But it would be quite unlikely to see it drop more than 5% or 10%.

That doesn’t mean there’s no money to be made. In fact, because of the overconfident market for WMT shares, there’s a real opportunity here.

To see how a bear put spread works, check out this diagram:

bearputspread

Source: The Options Industry Council

As you can see, yes, the profit potential is capped. But so is the risk. Since you’d be buying as well as selling puts, both ends are known right up front.

Let’s look at a specific example to show you what we mean.

A Specific Trade From WMT

Right now, a trader could buy a July 19 $100 put option on WMT for $1.67 per share and sell a July 19 $97.50 put option for $0.95 per share for a net debit of just $0.72 per share. On 100 shares, that’s a total cost of $72.

That’s the most this trade could lose in the whole month and a half it would be open. Considering this is less than the cost of a single share of Walmart, it’s clearly not a huge risk.

To find the maximum profit potential, take the difference in strike prices ($100 – $97.50 = $2.50) and subtract the entry cost ($2.50 – $0.72 = $1.78). So, since each option is worth 100 shares of WMT, that’s a potential profit of $178 on this trade.

Think about that. That would represent a 247% return on the amount at risk for this trade.

To collect this full return, shares of WMT would have to fall below $97.50 by July 19. As we write, Walmart’s shares are going for $102.25. In other words, to collect a full 247% return on risk, Walmart would have to drop just 4.6% over the next seven weeks. Considering in just the month of May, the stock outperformed the S&P 500 by 5%, this is certainly possible.

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