Trade Idea – $M Parade

by Dan October 30, 2015 2:48 pm • Commentary

Last week in this space we highlighted the relative under-performance of U.S. retail stocks as a group (as measured by the XRT, the S&P retail etf):

U.S. retail stocks are noticeably weak today, with the XRT, the S&P retail etf down 1.5% vs the S&P 500 (SPX) up 1.25%, and the Nasdaq Composite up 2.5%.  There are a couple ways to think about this. Amazon’s (AMZN) results last night may emphasize the growing disparity between those retailers with a vast online offering with cheap pricing and fast delivery/shipping options, and those that continue to struggle online (WMT/M/TGT).

Today’s retail weakness is more likely the result of poor results and guidance from VF Corp (who owns different apparel brands) and Whirlpool (WHR) who both struggle with dollar strength and tepid retail demand.  Adding to the weakness is the two day decline in Under Armour (UA) of about 8%

The XRT is up about 2% on the week and doing its best to test the highs of the one month range, seeing a marked change in sentiment:

XRT 6 month chart from Bloomberg
XRT 6 month chart from Bloomberg

This week’s price action in the space is fairly interesting when you consider today’s weak consumer confidence data and weak forecasts about the upcoming holiday selling season we’ve seen throughout the week.

But two U.S. retailers, Kohl’s (KSS) and Macy’s (M), that get all of their sales from the U.S. are having a good day, both are up about 3%. The sudden enthusiasm for has flowed into the options market as well. KSS call volume is 6x average daily volume with the largest trade of the day an opening purchase of 2500 of the Nov 47.50 calls for 1.15 when the stock was $46.14.  And in Macy’s, a trader bought 11,000 of the Jan 62.50 calls for $1 and sold about 210,000 shares at $51.  Interesting price action considering the stocks are down 40% and 30% respectively from their 2015 highs and both just bounced from 52 week lows.

What’s Next: November is going to bring a slew of retail earnings, with possible enthusiasm about a counter-trend rally into black Friday in the last week of November.  I am far from enthusiastic about the U.S. consumer, and I suspect that the October Jobs data (out next week Friday) may continue the two month trend of well below average non-farm payrolls gains.

The Macy’s out of the money call buy got me thinking of catalysts. Sentiment couldn’t be worse, despite its very cheap valuation (trading 11x fiscal 2017 expected eps growth of 11%.)  Earlier this year activist investor Starboard took a stake in the company and is pushing for a spin-out of their real estate holdings, which some investors think could be worth more than their existing market cap.   Early last year Macy’s management said 2015 would be an investment year, they bought Blue Mercury beauty stores and plan to open discount stores to compete with TJ Max. They’ve partnered with a retailer in Hong Kong to sell merchandise on Alibaba. They’re closing under-performing stores, pressing on in their omni-channel sales approach that includes online, and they’re in the midst of making real estate sales.  Management has been busy moving their feet, and investors seem to be discounting a lot with the stock down 22% on the year.

So what’s the trade?

I think it makes sense to play for a 50% re-tracement of the move from the 52 highs in mid July (from the low $70s) to the recent lows in the high $40s. That puts you the low $60s, very near today’s call purchase:

M 1yr chart from Bloomberg
M 1yr chart from Bloomberg

Options prices have blown out of late, with 30 day at the money implied vol near 50%, at multi-year highs:

M 3 year chart of 30 day at the money implied vol from Bloomberg
M 3 year chart of 30 day at the money implied vol from Bloomberg

The chart above does NOT speak to long premium directional strategies, but what becomes clear from the 1 yr chart of IV plotted against the one year chart of 30 day realized vol (how much the stock is moving) it becomes clear that options are being accumulated for a reason, possibly in front of some broader decision on a real estate spin:

M 1yr chart of 30 day atm IV vs realized from Bloomberg
M 1yr chart of 30 day atm IV vs realized from Bloomberg

And lastly, options open interest is at a 5 year high:

From Bloomberg
From Bloomberg

It sure seems like something’s up. And sometimes it makes sense to buy expensive vol.

Trade Idea:

M ($51) Buy Jan16 52.50 / 62.50 call spread for 2.50

-Buy 1 Jan 52.50 call for $3.50

-Sell 1 Jan 62.50 call at $1

Break-Even on Jan16 Expiration:

Profits: up to 7.50 between 55 and 62.50, max gain of 7.50 at 62.50 or higher.

Losses: up to 2.50 between 52.50 and 55, max loss of 2.50 below 2.50

Rationale – Vol is high, but in this case we can look out to January expiration for a 3 to 1 potential payoff on a move higher that retraces about 50% of the stock’s 30% decline from its all time highs made in July. While options prices have reached levels not seen in years, this has happened as the stock has gotten hammered despite what we see as a ton of potential positive catalysts to move the stock substantially between now Jan expiration. Considering how poorly the stock has acted since July, call spreads appear to be a much better way to be long Macy’s from a risk reward standpoint if it turns out we are in fact trying to catch a falling knife.