Holiday Retail: October Is the New December
Three weeks ago, I commented on a spike in consumer confidence in September. That month, the Consumer Confidence Index reversed direction and jumped more than 15 percentage points after declining the previous two months. I went on to note:
“If consumer confidence really is on the upswing heading into the holiday gift-buying season, most retail stocks should already be on the rise. The fact that they are not suggests Wall Street is more concerned about third-quarter results yet to be released than it is letting on. The dichotomy in confidence between individual consumers and Wall Street money managers creates an investment opportunity. One group will be proven right and the other wrong. In this case, I am siding with the consumers.”
Thus far, that prediction is proving true as evidenced by the third-quarter results released by Discover Financial (NYSE: DFS) on October 21. Despite a 6% drop in total revenue compared to the same period last year, Discover booked a 4% increase in diluted earnings per share.
The following day, Discover issued a statement explaining how it was able to improve its Q3 profits in the midst of a global pandemic. Long story short, it appears that a lot of consumers are already getting started on their Christmas lists. As the company’s CEO, Roger Hochshild, succinctly put it: “October is the new December.”
According to the company, sales volume increased by 4% in September and rose 7% during the first half of October. Hochschild attributes the pickup in spending to “A lot of retailers… telling their customers it’s a good time to buy early.”
Raking in the Money
That may be true. However, I believe the unexpected spike in consumer confidence last month was what triggered the surge in spending. If so, then that trend may carry over into the remainder of 2020.
That being the case, I will reiterate the recommendation I made three weeks ago. If you are looking for an easy way to participate in an uptick in retail spending, consider buying the SPDR S&P Retail ETF (XRT).
I also suggested buying a call option on XRT that expires on January 15 at the $46 strike price. At that time, that option could be bought for $6.
Last week, that same option was trading at $9. If you’d taken my advice, you’d be sitting on a 50% profit in less than a month. If you owned XRT over the same span, your gain would be roughly 5%. That’s the beauty of using options to bet on short-term trends in the market.
You may be wondering how a 5% increase in the price of the fund can result in a 50% gain in the call option. The answer is a bit complicated, but it has to do with the “intrinsic value” of an option and its “time value.”
The intrinsic value of a call option is the extent to which the price of the underlying security is above the strike price of the option. In this case, XRT has been trading above the $46 option strike price for the past three weeks.
For that reason, any further gain in XRT’s share price increases the options intrinsic value by the same amount. Three weeks ago, that option had an intrinsic value of $6. Now that XRT’s share price has risen by $2, that option has an intrinsic value of $8.
A Fly in the Ointment
But wait, there’s more! Our option does not expire for another 11 weeks. Between now and then, XRT’s share price could move strongly one way or the other. The extent to which the current price of an option exceeds its intrinsic value is referred to as its time value.
Since our option was trading for $9 when it had $8 of intrinsic value, its time value was $1. That works out to “implied volatility” of 38%. Implied volatility is an algorithmic measure of the extent to which XRT’s price is expected to oscillate until our option expires.
I think the implied volatility for this option understates the upside potential for XRT over the next three months. If what Discover Financial has experienced over the past month continues throughout the holiday gift-buying season, retail stocks could surge.
There is one fly in the ointment. XRT’s biggest positions do not necessarily reflect holiday retail spending. Its top 10 holdings include Carparts.com (NSDQ: PRTS), Stamps.com (NSDQ: STMP), and PetMed Express (NSDQ: PETS).
For that reason, you may be better off putting together your own portfolio of retailers. You could buy call options on all of them to amplify your results. Of course, there is more risk doing it that way, too.
That’s why I suggest you consider following the advice of my colleague, Jim Fink.
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