Trade Spotlight: 8/21

Our last insight discussed how value investors must be able to master the art of capital preservation and be able to read macro conditions in order to maximize investment returns.

The theme of prudent trading continues in this piece, a dual education and trade spotlight article, in which we will discuss our top trade idea for the week, but also a different, smarter, way that long term investors can trade this setup.

There are many ways to go about a trade.

Different people like to employ different methods, such as buying long options or dollar cost averaging (DCA) into their favorite stocks.

As value investors, this is another key aspect of trading we must master.

What type of trade to use and when to use them.

Normally simply buying shares of a depressed stock isn't optimal, as the stock can continue going down and now you're left with a high average share price.

On the other hand, waiting till a reversal might be too long and you may miss the best possible entries while sitting on your hands.

DCA'ing is great, but if similar to buying too early, if you start averaging in too early, your final average may be too high and there's even a chance the stock dips so far that you end up running out of funds to continue averaging down into the position.

You miss returns sitting on your hands and going in risks leaving you in a bad spot...

So what do you do?

Well, this brings us to one of my favorite trading strategies, writing options.

Writing an option refers to selling an options contract in which a premium is collected by the writer in exchange for the right to buy or sell shares at a future price and date.

Or in other words, you are shorting the option instead of buying them long.

For our purposes we will assume that we are using either covered calls or cash secured puts as our two strategies rather than naked options which carry unlimited risk.

Let's go through each of them:

Cash Secured Puts

Cash secured puts is a bullish strategy that I prefer over both DCA and buying shares directly as it provides both averaging opportunities as well as income without owning the shares.

CSPs involve shorting put contracts and earning the premium of the contract.

Let's go through and example to make it easier:

For this example we are going to assume that stock $XYZ is trading at $100.

If we want to go long on $XYZ we can "sell to open" a put contract.

In this case at $100, the $100 put contracts expiring that Friday are worth $5/contract.

Since options transactions are in 100 share lots, you sell to open one contract and earn $500 in premium ($5.00 x 100 shares).

However, you are selling the right to buy the stock at a certain price, meaning you will have to dedicate, in this case, $10,000 (100 shares at $100/share) towards potentially having to buy the stock if it closes below $100/share once the option expires.

Here are the potential scenarios in this case:

• If the stock closes above $100/share when the option expires, it is worthless and you walk away with the full $500 in premium (a 5% return on the $10,000 you put up)
• If the stock closes below $100/share when the option expires, you are "assigned" shares. These shares will be bought using the $10,000 you initially put up and are averaged at (the strike of the options contract - the options premium), which in this case is $100 - $5 = 100 shares at an average of $95.

This can be lucrative if the stock closes at $99/share as you now own shares at an average of $95 even though the stock may never have actually traded down to that price.

• Finally, in the worst case scenario, the stock not only closes below $100, but also your average price at $95. Now you will still be assigned shares, but you will be at a loss if the stock is trading at lets say $90/share by then.

In all selling puts gives traders flexibility in entering a position, and if executed correctly on beaten down stocks, can allow investors to buy into positions at extremely cheap prices.

Alternatively, you can also trade the put.

If the stock begins to go up in the middle of the week and the value of the put contract goes from $5 to $3, you can use the $500 in premium you earned to "buy to close" the position and buy back the puts at $3/contract, or $300, profiting the $200 difference.

Covered Calls

Covered Calls work in a similar way, but you are shorting call options instead, and rather than having to put up cash as collateral, in this case you will be putting up shares.

CCs help to generate income while already in a long position, as well as allow investors to limit downside.

For this example we are going to assume that stock $XYZ is trading at $100 and you already own 100 shares (maybe you got assigned...)

In this case at $100, the $100 call contracts expiring that Friday are worth $5/contract.

You expect the share price to remain flat/go down over the week, so you "sell to open" a call contract.

Each covered call contract will "cover" 100 shares, so when you sell to open one contract you earn $500 in premium ($5.00 x 100 shares).

Here are the potential scenarios:

• If the stock closes below $100/share when the option expires, you keep all $500 of the premium as well as your 100 shares.
• If the stock closes above $100/share when the option expires, your shares get exercised or sold at (strike price of option + premium), in this case $100 + $5, or $105/share.

In both scenarios you are profiting, either by making extra income while the stock goes down or by being able to sell your shares at a price higher than your buy price.

In the worst case scenario the stock price rises by more than your premium, in this case maybe the stock spikes to $110, now you are forced to sell at $105 despite the market price being higher. While this isn't exactly a loss it is still a loss in relation to the maximum profits that could have been made.

Alternatively, you can also trade the call.

If the stock begins to go down in the middle of the week and the value of the put contract goes from $5 to $3, you can use the $500 in premium you earned to "buy to close" the position and buy back the calls at $3/contract, or $300, profiting the $200 difference.

With these two strategies defined, lets take a look at our Trade Spotlight...

On a long term perspective the current pullback in Estee Lauder's stock is staggering, trading down to its Covid lows.

Why?

Well the stock is down for plenty of reasons, with the foremost being the fact that international sales for the company have been extremely weak, prompting management to cut guidance repeatedly to reflect softer consumer dynamics.

And this has beaten the stock severely.

The cosmetics giant is down over 60% from it's all time highs... but earnings are still growing, albeit slower than Wall Street would like.

The main issue for EL is China.

Their sales within China have cratered this year, which given China's current economic state, is to be expected.

China's domestic consumerism remains weak. July's retail sales growth of 2.5% was down from June's growth of 3.1%, falling considerably short of the expected 4.5% growth.

More importantly, cosmetics sales in China fell 4.1% year over year in July, with many consumers opting for lower-cost brands.

However, the problems don't stop in China.

Europe and Africa are where EL's biggest slumps lie, and we expect this to ease significantly as it seems more likely the global economy will be able to sidestep a recession, with consumers eventually easing back into their old spending habits.

With growth still expected to be 5-7% for the year and 2024 EPS guidance sitting at 3.50/share, we see EL to still be a top option in the cosmetics space and expect the share price to considerably rebound.

With that being said, we see Estee Lauder's current stock price as a reflection of every bad piece of news and guidance piled into one.

An extreme overreaction.

Making this a unique opportunity to buy into one of the most stable growth companies on the market.

Here is our trade strategy:

Here is where our options writing can come into play.

With EL trading at $150, we see writing puts to be the best option for investors.

In this case we would sell September 15th $155 strike puts for $7/contract.

This means that if the stock closes above $155/share by the options expiration, you earn $700 for every 100 shares worth of capital put up ($15,500), representing a 4.5% return.

On the other hand, if the stock closes below $155 you are assigned shares at an average of $155-$7, or $148/share, a great deal.

Asides from this, we would also, as usual, encourage investors to simply buy shares long as this particular trade is likely to be very lucrative within a long term (18+ month) scope.

We expect Estee Lauder stock to appreciate at least 60% over the next 18-24 months and as a result see it as a no brainer option for both a shorter term (6 months) and longer term trade.

In all, we see this as a two-phased trade.

The first is a simple technical move for the stock to both close its upside gap as well as reclaim its 200-week moving average.

This technical move alone represents over 50% upside in share price, albeit with some downside risk in the form of support retests.

The second phase of this trade would be more long term and would be entering 2024-2025, and is more fundamental oriented.

As the economy improves and the company successfully navigates their current financial woes, the stock will begin to test residual resistance levels from its post-covid boom, and ultimately push further towards its all time highs over 150% higher from its current price.

Estee Lauder is a cosmetics staple and is a great addition to long portfolios at this level, with their dividend being an added bonus for investors.

-Andy's Angle Writing Team-