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“Big Dog” is a phrase I use to describe a large, successful, well-respected company whose stock has been performing, ahem, not well.  

Now if you’ve read my articles in the past, you know that I am something of a “systemaholic” and generally prefer to have all of the rules laid out in advance.  Nevertheless, I have this “darker side” that likes to occasionally look at things from a common sense point of view and attempt to profit.  I find options to be extremely useful in these situations because I can take a common sense approach and attempt to profit without tying up a ton of trading capital or risking my shirt.  

The basic intent of looking for Big Dogs is to peruse the market looking for companies that are likely to not only survive, but potentially (or at least hopefully) thrive in the future, and whose stocks are either beaten down or at the very least building a long-term base (also known in layman terms as “going nowhere for as long as I can remember”).  There are several stocks that fall in to the Big Dog category as of late. Among the “beaten down” category we have Eastman Kodak (EK), Merck (MRK) and 3M (MMM).  In the “going nowhere” category the most obvious choices are Microsoft (MSFT) and Wal-Mart (WMT).  Let’s take a look at some potential longer-term option plays for Wal-Mart.

Wal-Mart is probably the most beloved company in the country.  It is also likely the most hated company in the country.  Regular shoppers love it because of their low prices while others seems to hate it because it has become such a leviathan whose business practices create huge waves which ripple throughout the business world.  Some people even do both.  For example, I myself dread going to Wal-Mart.  The store near me is older, grungy, crowded and has somehow acquired that funky popcorn smell (hey, when did they acquire K-Mart?).  I hate every minute of my shopping experience – right up until the point when I check out.  And then I remember why I came in the first place.  

As this is written, Wal-Mart stock is changing hands near $45 a share.  And this is significant because Wal-Mart stock first traded at that price in April of 1999.  In other words, despite the fact that Wal-Mart has spent the six years since then essentially trying to take over the world (and some would suggest that they are succeeding), the price of the stock has gone exactly nowhere.  Basically what has happened is that as Wal-Mart has matured and grown investors have come to realize that the type of growth that the company experienced in the 1980s and 1990s is not going to continue at the same pace.  As a result, what has seemingly been marked down the most is not the everyday low prices of the goods they sell, but the price/earnings ratio for the stock itself.  

Chart 1 – Wal-Mart Stock

For the first time almost since it began trading, Wal-Mart stock is trading at roughly the same P/E ratio as the overall market.  Now if I were a skilled fundamental analyst I would immediately launch into an in-depth analysis of how much Wal-Mart has grown in the past six years versus other companies and the economy as a whole.  I would also talk about future projections and argue that Wal-Mart stock should be poised to rise in the years ahead.  But the truth is I hate all that stuff.   So let’s just look at it from a common sense point of view.

• The largest, most dominant, most influential consumer retailer in the world is selling at the same “price” (with P/E ratios being used here as a proxy for relative price) as the rest of the rabble. 
• The stock of this large, dominant, influential company hasn’t gained a nickel in six years despite a tremendous growth in business.
• There is no reason to think that Wal-Mart’s business model will fall apart anytime soon (and in fact there is no real reason to think that the company’s prospects won’t continue to improve).

So given all of these common sense perceptions, if I were a skilled stock picker I would immediately launch into an argument as to why Wal-Mart is presently offering a tremendous buying opportunity.  But the fact of the matter is – while six years of sideways movement is indeed a long time – there is no reason why the stock should immediately take off.  The pressing question is “where’s the catalyst?”  Now if I were a skilled retail stock analyst I would immediately launch into a long-winded explanation as to how and why Wal-Mart’s business plan is due to generate a tremendous pickup in business in the immediate future and why this will prove to be the catalyst which drives the stock price higher and why now is exactly the time that investors should pile into WMT shares forthwith.

Alas, I am none of these things.  I am not a fundamental analyst, not a stock-picker and not a retail stock analyst.  I am simply a lowly speculator trying to find a trading opportunity.  And common sense tells me that there is one here.  Given Wal-Mart’s dominant business position, I feel pretty confident that eventually the stock will rise.  The obvious questions then become, “how soon” and “how much do I want to risk if this opinion is wrong?”  This is where options can become quite useful.  

The bottom line is that I have no idea what the catalyst might be that would finally get WMT moving upward again.  I do know that it recently bounced off of a multi-year low.  So if common sense tells me that the company is likely to thrive in the long run and the stock is presently near its lowest level in almost 5 years, it’s not that great of a leap of faith to believe that now may be a good time to enter a bullish position.  So given that perception the next question becomes “how to play it?”

Let’s assume we are willing to risk about $1,000 on a trade and that we are looking at a one-year time frame.  In that case two obvious choices are:
1. Buy a call option
2. Buy a call backspread

The other obvious choice that I did not mention would be to simply buy the stock.  But there are two reasons for not doing so.  First, remember that this idea is based more on a common sense hunch than on an objective set of buy criteria.  Secondly, to buy 100 shares at the moment would require approximately a $4,500 commitment.  As you will see, by using options I can obtain a great deal more profit potential with a much smaller capital commitment.  

BUY A CALL OPTION

The advantage of buying a call option in this situation is that you obtain unlimited profit potential if WMT shares finally begin to move to the upside.   At the same time your risk is limited to the amount you paid to buy the options.

Figure 1 depicts one possibility which is to buy two at-the-money January07 LEAP options with a strike price of 45.  As this is written these options are trading at $5.90.  So it would cost $1,180 to enter this trade and our upside breakeven price is 50.90 (the strike price of 45 plus the premium paid of 5.90).  This represents only 26% of what it would cost me to buy 100 shares of the stock.  


Figure 1 – Buy 2 WMT Jan07 45 Calls

Chart 2 – Long Two Jan07 45 Calls

If WMT were to retest it’s 12-month high above 58, this trade would show an open profit of approximately $1,500 to $1,700 depending on whether that target was reached sooner or later.  This trade would lose $1,000 or more if WMT fell to about 40 or below prior to option expiration.  So a trader could not necessarily put this trade on and forget about it, as he would have to watch and see if the recent low of 42.31 held and then decide whether or not he wants to cut his loss.    

BUY A BACKSPREAD

The advantage of buying a backspread in this situation is that you stand to profit if the stock goes up or down far enough.  The risk of loss associated with this trade occurs if the stock stays relatively unchanged.

Figure 2 depicts one possibility which is to sell two January 07 35 calls at 12.90 and buy two January 07 45 calls at 5.90.  


Figure 2 – Sell 2 WMT Jan07 35 Calls and Buy 2 WMT Jan07 45 Calls

Chart 3 – Risk Curve for WMT Backspread

As you can see in Chart 4, the maximum risk on this trade is almost $1,800, however that would only occur if we held this trade until expiration (Note: if you never hold a backspread until expiration you will never experience the maximum risk on the trade).  Because we are looking to hold this position for a maximum of one year, our maximum downside risk is approximately $1,100 to $1,200 dollars.  If WMT were to retest it’s 12-month high of 58, this trade would show an open profit of approximately $900 to $1,500 depending on whether that target was reached sooner or later.

COMPARISONS

The cost to enter the long call trade is $1,180 (or $5.90 x $100 x 2 contracts).  This also represents the maximum potential risk on this trade.  Most brokers calculate the amount you need to put up to enter a backspread as follows:

• The difference between the strikes minus the premium received
• Plus the amount paid to buy the additional options

In this case we sell two 10-point spreads for $7 apiece (35 and 45 strikes at prices of 12.90 and 5.90), then buy two additional calls at $5.90.  So the capital requirement goes like this:

• We received 7 points on a $10 spread (selling the 35 call at 12.90 and buying the 45 call at 5.90), thus we need to put up 3 points, or $300 per spread, or $600 in this case since we are selling two spreads.  
• We must also pay $1,180 to buy the two additional 45 call options at $5.90 each (is this fun or what?!).  As a result, to enter the backspread depicted above, our broker will likely require us to put up $1,780.  This represents the maximum risk on the trade, however, we can easily reduce this risk by making certain to exit this trade well in advance of expiration. 

Table 1 depicts the expected dollar and percent rate of return for both trades given the price of Wal-Mart as of 10/21/06.

Table 1 – Profit/Loss Comparisons

DECISIONS, DECISIONS

There are any number of other trade possibilities associated with the suggested scenario for WMT.  The point here however, is primarily to show you how to compare opportunities and determine the relative advantages and disadvantages in order to decide which trade appeals most to you based on your own reward/risk preference.  

So assuming that a speculator wants to bet that WMT will rise back toward 55-60 over the next twelve months, and is willing to risk about $1,000 on a trade, then which trade is best?  Unfortunately, that is one question that I cannot answer for anyone other than myself.  

So which trade will work out best?  As always, time will tell.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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