Wednesday, January 16, 2013

BIG's small breakout

Update: I closed the position on April 1 when the price fell below the lower boundary of the 10-day price channel, $34.60. The price quickly retreated back within the channel, but under my rules, it will take a new breakout from the 20-day price channel before I open a new BIG position.

The position was closed for a 10.3% gain on the underlying stock. My holdings were structured as long calls expiring in April. The initial options position yielded 47.9%. 

I added to the position several times during its lifetime. Calculating from the average basis and exit, the underlying stock was closed for a 5.7% profit, and the options for a 4.4% loss.

I'll post an essay about adding to positions later, but I'll just say here that I've had a run of positions where the additions turn a winning trader into a loser. Must fix that.

The closeout retailer Big Lots Inc. (BIG) broke above its 20-day high on Tuesday in an 8.7% four-day climb from $27.52 to $29.92.

The move is part of a sideways pattern that has held sway since a 13% earnings miss published on Aug. 23 caused a massive downward gap in the stock price. Big picture: The price has been declining in a stair-step fashion since peaking at $47.22 last spring.

BIG has a slight edge on upside breakouts -- 56.3% have been profitable since January 2009. The average yield of successful trades is high, at 14.9%. Adjusted for the success rate, the average yield works out to 8.4%.

Altogether 18 stocks and one exchange-traded fund among the 1,051 I'm tracking broke beyond their price channels on Tuesday, 15 to the upside and four to the downside.

Eight, including AAPL, which broke to the downside, were removed from consideration because of earnings announcements scheduled in the next 30 days. Four were removed from consideration because they dropped back into their 20-day price channel on Wednesday.

Only two of the remaining had success rates above 50%. The other is Cabela's Inc. (CAB), which also broke out to the upside. It has a success rate identical to BIG's, but a higher average return, 23.7%.

I decided on BIG because CAB's follow-through was too robust. By the time I could even consider a trade, its price had moved 32% above the breakout level. To my mind, that's a set up for a significant pullback as successful traders' take profits.

BIG's breakout was far smaller, but even small breakouts can be profitable over time. As a trader, I actually prefer stocks that quietly slip beyond the price channel, like Navy SEALS on a covert mission, rather than roaring out accompanied by 76 blaring trombones and an Olympic-class fireworks display.

Sometimes, in trading, small is beautiful.

BIG will win no popularity contests among analysts, which is no surprise in light of the August earnings miss. The enthusiasm index runs at negative 38%.

That seems short sighted (Short sighted? The markets?? How dare you, Sir!) in light of Big Lots'  longer-term numbers. Return on equity is 24%. Debt amounts to 73% of equity, higher than I like but not crippling by any means.

The most recent quarter, reported in December, did indeed show a loss, although it surprised to the upside. The 11 quarters before that were all profitable, including the big August earnings miss. Altogether, Big Lots has surprised to the upside in eight of  the past 12 quarters, and to the downside four times.

These are not awful numbers. Certain, the story-minded can construct a narrative about economic recovery encouraging shoppers to move from discounters like Big Lot toward higher end retailers. Given the slow pace of recovery, I wouldn't bet on it.

Institutions own nearly all of BIG's shares -- itself a vote of confidence -- and the price is really, really cheap. It takes just 32 cents in stock to control a dollar in sales.

So for people who look at the financials and analysts, BIG would seem to be a reasonable contrarian play.

However, we are all technical traders here, yes? We play the charts and odds and never fiddle-faddle with the financials.

BIG on average trades 872,000 shares a day, sufficient liquidity to support open front-month open interest in the three figures but not a very wide selection of option strike prices. The front-month at-the-money bid/ask spread is moderate, at 5.9%.

Implied volatility stands at 35%, just below the middle of the six-month range. It has been stair-stepping downward since Dec. 31.

Options are pricing in confidence that 68.2% of trades will fall between $26.69 and $32.77 over the next month, for a potential profit or loss of 10%, and between $28.27 and $31.19 over the next week.

The fair-price zone on today's 30-minute chart extends from $29.85 to $30.26, encompassing 68.2% of transactions surrounding the most-traded price, $30. Two hours before the close, BIG is trading slightly below the zone.

Big Lots next publishes earnings on Feb. 25.

Decision for my account: The options were (barely) liquid enough to trade, so I opened a bull position, structuring it as a bull put option spread expiring Feb. 15, short the $27.50 put and long the $25 put. The spread is profitable down to $27.25, providing a 7.9% cushion. The yield is low, only 9.1%, although I would argue that diversity in yields is a good thing for a trading account.

If the price continues to rise, I shall add to the position by buying call options expiring in April with deltas as close to 70 as I can manage.


My trading rules can be read here. (They don't talk about the trend score because I'm still developing the tool.) A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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