DFS: Credit-card bull signal

Update 6/21/2013: I've closed DFS for a small loss. A market break to the downside just before expiration moved the position from profitable to loss-making. The stock price rose 0.6% from my entry to my exit. I added to the position three times, and the stock at exit stood 1.5% below my basis.

I structured the position as vertical option spreads sold for a premium. The yield on risk was negative 1.1% -- a loss.

Update 5/7/2013: I had delayed entry into DFS until it went ex-dividend. It has, and I opened a bull position, structuring it as vertical credit spreads expiring in June, short the $46 puts and long the $42 puts. The maximum potential yield at expiration is $20.3%, and the position provides a 2.3% cushion between the entry price as the break-even price.

Discover Financial Systems (DFS) today confirmed a bull signal triggered Friday when it broke through the upper boundary, $45.61, of its 20-day price channel.

The stock has been in a major uptrend since June 2010, saw a major correction the last half of 2011, and resumed the uptrend in January 2012.

This is DFS's 7th breakout to the upside since the uptrend resumed. Of the six completed trades, half were successful for an average yield of 14.9%, and half failed, for an average loss of 5.4%.

The win score -- yield on winning trades adjusted by the success rate -- is an excellent 7.5%, and the spread between averaging yields on winning trades and losses on failures is a respectable 9.5%. Those numbers give DFS an edge for success, even with a 50% success rate.

Winners have had a slight edge since early 2009, when the broad markets began to recover from the post-recession crash. Of the 17 completed trades since then, nine were profitable for an average yield of 18.5% and eight failed for an average loss of 8.4%.

Discover Financial Services, headquartered in Riverwoods, Illinois, runs Discover credit cards, a business that accounts for more than two thirds of the company's market capitalization.

Analysts tend to love DFS's prospects, collectively coming down with a 50% enthusiasm rating. The company's financials no doubt fuel the love. Return on the equity is 25%, although the fact that debt is double equity leaves DFS stranded far from growth-stock territory.

Earnings rose steadily through 2010 and 2011 and then hit a very high plateau. DFS has surprised to the upside in 10 of the last 12 quarters, and to the downside in two.

Institutions own 88% of shares, a high level, and the price has been bid up to the point where it takes $2.89 in shares to control a dollar in sales.

DFS on average trades $5.1 million shares a day and supports a moderately broad selectoin of option strike prices, mainly with three-figure open interest and a 5.4% bid/ask spread on front-month at-the-money calls.

Implied volatility stands at 24%, near the floor of the six-month range. It has been moving sideways since late April.

Options are pricing in confidence that 68.2% of trades will fall between $42.76 and $49.18 over the next month, for a potential gain or loss of 7%, and between $44.43 and $47.51 over the next week.

Trading in options is heavy on the put side, at 2-1/2 times the five-day average volume, and calls are running at 3/4 average volume.

The fair-price zone on today's 30-minute chart runs from $45.79 to $46.17, encompassing 68.2% of transactions surrounding the most-traded price, $45.92. DFS started the day with a run to the upside in the first hour of trading, followed by a run to the downside. With 3-1/2 hours to go before the closing bell DFS is trading near the most-traded price.

Discover Financial Services next publishes earnings in July, most likely. The stock goes ex-dividend on May 7 for a quarterly payout yielding 1.74% annualized at current prices.

Decision for my account: I like DFS as a bull trade but want to wait until after it goes ex-dividend before entering. I'll look at it again on Tuesday or Wednesday, see if I still like the chart. The effect of the dividend is likely to be small, but I see no reason to add that complication, however slight, to the trade.

References

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

At several points in my analysis I use the number 68.2%. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Disclaimer

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.