An Income Trade With a 90% Chance of Delivering Profits

StreetAuthority Network

Most analysts agree that FedEx (FDX) is a great company. It virtually created the private express shipment business, starting with an idea in 1971, and growing to a company moving an average of 10 million items a day with a fleet of more than 90,000 trucks and over 660 aircraft. Revenue has grown to $42.7 billion a year, and while the fact that FedEx is a success is undeniable, there have been stumbles along the way.

The most recent stumble came on March 20, when FedEx missed earnings estimates for the quarter that ended Feb. 28, the third quarter of the company's fiscal year. Analysts had been expecting FedEx to report earnings per share (EPS) of $1.38, but the company delivered EPS of only $1.23. Traders reacted by selling the stock.

FedEx's CEO said that the company would be focusing on controlling costs going forward. The CFO added that results in the troubled Express division should "be a whole lot better" in the fourth quarter. For the full year, FedEx management told investors to expect earnings to come in between $6 and $6.20 a share.

After a sell-off from its 52-week-high of $109.66 this month, shares currently sit around $97.50, making now a good time to look at FDX as a potential investment. To do this, we need to remember that stock markets are said to discount the future, which means current prices are based on how well a company is expected to do in the future.

Analysts expect FDX to report EPS of $7.62 for the 12 months ending in May 2014. That would represent an increase of 25% compared with the current fiscal year. Early estimates for fiscal year 2015 are for EPS of $9.36, growth of 23% from expected 2014 results. Longer term, analysts expect growth to average 12.8% a year for the next five years.

Some investors use the PEG ratio to find the fair value of a stock. The PEG ratio compares the price-to-earnings (P/E) ratio and EPS growth rate. A company is assumed to be trading at fair value when the PEG ratio is equal to 1. Rather than apply the formula in theory, let's use the real numbers for FDX.

Using the expected earnings for 2014 and the long-term EPS growth rate of 12.8%, this means the PEG ratio would be equal to 1 when the P/E ratio is also 12.8. FDX should be trading at about $97.54, according to this model (12.8 x $7.62 EPS), about the price that it is trading at now. We use the expected earnings because markets discount the future, or look ahead. Because of this, current stock prices are usually based on future earnings prospects, so it makes sense to use the forecasts when they are available.

While I would not buy FDX at this price, I do recommend a put selling strategy. Put options give the buyer the right to sell 100 shares of a stock at a predetermined "strike" price for a predefined amount of time. Put sellers have an obligation to buy the stock if the seller decides to exercise the option, which they will do if the stock declines below the strike price.

For FDX, the chance of an additional short-term decline seems small. With little chance of a drop to $90 a share over the next month, for example, traders selling puts with a strike price of $90 that expire in April have a high likelihood of keeping the premium as pure profit. That option is trading at about $0.23, so a seller earns income of $23 per 100 shares. Brokers will generally require a margin deposit equal to 20% of the strike price, or $1,800 in this case. The return on investment of a winning trade would be about 1.3% in less than one month, or about 15.6% a year if a similar trade is repeated 12 times a year.

This is an example of how to turn bad news in a good stock into income. After the initial drop in the stock, there is generally a low chance of a large further decline in the next month. For FedEx, options pricing models indicate there is about a 10% chance of another big drop, meaning there is a 90% probability that options sellers will profit from this trade.

This may seem like a small trade, and it is. But it is a high-probability trade. I cover ideas like this, usually with even higher income potential, in my weekly Income Trader newsletter.

Recommended Trade Setup:

  • Sell FDX April 90 Puts above $0.20 (use a limit order to ensure this price or better)
     
  • If FDX is trading above $90 when the option expires on April 19, you will keep 100% of the premium collected
     
  • If FDX is trading below $90 when the option expires on April 19, you will be required to buy the stock at an 8% discount to current prices

Related Articles

View Comments (0)