There’s a type of trade I don’t think I’ve introduced to Insights & Indictments yet, but this is too perfect of an opportunity to pass up.
This company that I’m about to recommend you move in on is about to make a major move. The only problem is that it’s set up to swing either way.
That’s why we’re getting creative.
First, I’ll explain what I plan we do, and then I’ll lay down the dirty details on this company. It’s struggling with some major lawsuits over a recent acquisition, but the stock has been steadily rising over the past week. Position yourself right and you stand to make serious gains no matter what happens next.
A straddle is a fairly generic strategy.
It means you want to straddle the market or a stock, and that you want be on the fence. To play both sides.
In the options world, a straddle typically involves buying a call and a put at the same strike price.
Let’s say XYZ’s trading at $50.25, and there’s a rumor that a private equity company might make a bid to buy the company. But, at the same time, the earnings have been bad for XYZ and they’re supposed to come out shortly and disappoint investors again.
Entering a straddle by buying the $50 strike calls and the $50 strike puts, with maybe two months to expiration for both the options, means an investor is hoping either the stock races higher on a buyout bid or crashes because the earnings come out in the toilet (so to speak).
It doesn’t matter to the investor which way the stock goes, he’s straddled. He just wants it to do something, something big, in either direction.
If the stock doesn’t do anything and stays around $50 by expiration, both the calls and the puts will probably expire worthless and the investor (trader) will lose what he paid for both.
But if the stock makes a big move either direction, the investor hopes to make a lot of money on either the calls or puts. Enough to cover what he’s paid for both options, and then some.
We’ll put on straddles now and then. But more often, we’ll put on “modified straddles.”
All that means is that the puts and calls we buy won’t necessarily have the same strike price, and may not have the same expiration. We’re just modifying a typical straddle format to suit our expectations.
It’s still a straddle. We’re still hoping the underlying stock makes a big move one way or the other.
Typically, when putting on a straight straddle, you can send the order down as a straddle with a price (for both positions) designated. Your broker can then buy both the calls and puts together as long as the total price for them is what you are trying to buy the straddle for, or maybe less.
You don’t have to put down the order as a straddle. You can “leg” into the position, which is kind of what it sounds like. There are two legs holding up a straddle. You can buy one side, the calls or the puts, and put down a separate order to buy the other leg.
Generally, when I have us put on modified straddles I want us to leg into each side. Buy them separately.
We want to try and buy them at the same time so we have both legs in place. But sometimes we won’t be able to buy one leg (or both) because it’s above the prices I recommend we buy at.
There are reasons that may happen. The stock could move before you get the instructions, it could move while you’re putting on one leg, or possible other circumstances.
It doesn’t matter if you only get one leg, and the other leg is above the recommended price. You can go ahead and buy the missing leg if you don’t mind paying up above the price I recommend. That’s fine – as long as you don’t pay too much more.
If you don’t chase the leg you’re not able to buy, that’s okay too.
I determine the prices for each leg based on what I think (mathematically) are good entry points, where we can get into the whole straddle and not overpay for one leg or both.
Sometimes we’ll be in one leg and it will be the right one, sometimes we’ll be in on one leg and we’ll have wished we’d gotten the other leg.
And, then again, sometimes bad stuff happens and we lose out on both legs because we get into both legs and the stock does nothing.
I don’t worry about small losses, you shouldn’t either.
Next up, we’re getting into a modified straddle on Dollar Tree Inc. (NASDAQ:DLTR).
The Dollar Doesn’t Fall Far From the Tree
We’re buying calls of DLTR, in spite of our distaste for bricks-and mortar-retail stores, of which DLTR has a whopping 14,200. DLTR appears to be making some good money lately.
Based on year over year measures, sales were up 13.7% to $2.5B on a trailing four quarter basis, and operating cash flow has been stronger. In particular, 3 out of past 4 quarters have seen “outperformance” while one quarter showed “mild underperformance.”
Meanwhile, and this is a big reason cash flow’s been increasing, capital expenditures (capex) is a little more than half of what it was several quarters ago. That’s a big drop.
A lot of the capex (as it was classified) was due to the company’s elevated spending following the acquisition of Family Dollar stores a few years ago.
As a result, “cash clearance” on an annualized basis has risen from $122.5MM as of Q3, to $180MM in Q4. It’s now up to $229.5MM as of Q1 2017.
That’s ridiculous, nearly doubling over six months.
The stock’s just past $70 bucks now, it looks attractive, and we’ll be buying calls to reflect that.
But all that being said, this company is still a bricks-and-mortar retailer with 14,200 stores. And what’s truly crazy is that they’re talking about getting the store count up to 25,000.
No, that’s not a typo.
We get it, stores like The TJX Companies Inc. (NYSE:TJX) have been bucking the negative death spiral facing most retailers, for all the reasons we know. But off-price and brand-name discounters, no matter how fast they turn over their inventory, or how much fun it might still be to physically shop for “finds”, are still going to be upended by the Internet.
DLTR stores are not immune.
The more stores they open, the more cash they’ll divert to that effort, and the more debt they’ll to accumulate (and they already have a $6.3 billion pile of the stuff), the more pressure there’s going to be on the stock.
In spite of all the “positive” news coming out of DLTR, its stock (even though it looks like a bargain) has been slumping and is near its recent lows.
What’s up with that?
Part of what’s going on is that there are major lawsuits flying over DLTR’s acquisition of Family Dollar.
A bunch of stores were hived off of the company’s roster to clear regulators’ heads during the acquisition. The resulting stores were supposedly staffed with “unqualified” and “inattentive” store managers and DLTR is accused of using confidential information on the spun-off stores to disadvantage them and make way for DLTR stores to be thrown up close enough to the spun-off stores to damage them irreparably. The private equity company that backed the new stores is mad as hell. One suit seeks $500 million from DLTR in “lost prospective value” plus damages.
While the merits of the suit aren’t immediately compelling, it’s still a legal case, and anything can happen in a courtroom.
If DLTR’s stock was acting better here, we might just take the call options position and then cash out to find a place to get into a put position.
But the stock is not acting well, and that’s because of the lawsuits and the fact that the company’s aggressively pushing its 25,000-store plan.
That’s why we’re buying puts… And because we just hate big bricks-and-mortar retail chains.
For the calls, buy DLTR August 18, 2017 $75 calls (DLTR170818C00075000) and pay up to $0.95. Then, for the puts, buy DLTR November 17, 2017 $50 puts (DLTR171117P00050000) and pay up to $0.55.
Go get ’em.