Written by Fastball
Published under Retail
April 29, 2012
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Wal-Mart (WMT) sold-off recently from news regarding alleged bribery activities in Mexico. If true, this is clearly a violation of the Foreign Corrupt Practices Act. Wal-Mart will face steep penalties if convicted, but no one knows exactly how much at this point. However, even if they get fined $1-2 billion it won’t bring the company down. That’s a big one-time earnings impact, but the Wal-Mart business would carry-on.
The bigger risk is management distraction and its impact on Wal-Mart’s operations and execution. This investigation will consume a lot of the valuable executive leadership’s time. Will they be able handle the load and still stay ahead of the competition?
In 2012, WMT has stayed within a general range between $58 and $62 except for the recent, brief dip resulting from the bribery allegations. WMT has recovered from those losses, closing on Friday around $59. I don’t see too many catalysts that would send WMT out of this $58 – $62 range. The two most important items to watch are:
I will apologize for this trade ahead of time. It’s a good trade, but it’s also more complex than I usually like to present on this site. We prefer to focus on keeping investing simple. This trade itself is a bit more complex, but at least it shows you a relatively easy, higher probability way to generate income.
For this trade, we are selling an out-of-the-money put spread and selling an out-of-the-money call spread. In this way, we are gaining from all of the options expiring worthless if the stock finishes within our range. We get to pocket the income on the puts and calls that we sold. This trade is known as an Iron Condor.
The trade has 4 legs:
This produces a net $750 income to your account. We will keep the full $750 if the stock is between $57.50 and $62.50 at expiration in three weeks. This trade will break-even as long as the stock is between $57 and $63. That gives us a 3.4% cushion on the downside and a 6.8% cushion on the upside.
We are setting aside $20,000 in our portfolio, but the trade itself only requires $3,000 to execute. Because we bought options at $55 and $65, our max risk of loss is capped at the $3,000. If we had simply sold the $57.50 puts and $62.50 calls, then we could have generated more income, but our risk would be uncapped. We much prefer to have risked capped whenever possible.
The $750 of income will get us a 25% return on the $3,000 at risk and a 3.75% return on the $20,000 that we are setting aside in the portfolio. However, we may forgo some of this income and close the position before Wal-Mart reports earnings on May 17th. These options expire on May 18th, but selling before the earnings announcement will remove the risk of a large move outside our expected range. We’ll see how the stock plays out and adjust accordingly. Regardless, we should be able to get the majority of our $750 earnings…as long as the stock plays along of course.
Disclosure: Dave does not currently own WMT.
