As a rule of thumb, the financial publication industry prefers directional stories — and usually positive narratives at that. Unfortunately, certain edge cases like big-box retailer Target (TGT) make directional narratives difficult, if not outright impossible. Essentially, the business is giving mixed signals, suggesting a sentiment tug-of-war. This ambiguous circumstance arguably forces a nuanced perspective.
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Much of the confusion centers on Target’s second-quarter earnings report published last week. On paper, the company performed well. Earnings per share landed at $2.05, narrowly beating Wall Street analysts’ consensus view of $2.04. On the top line, the retailer generated $25.21 billion, beating the expected print of $24.94 billion. Sadly, that wasn’t enough for investors, who ultimately saw TGT stock lose nearly 6% last week.
So, the big question: what the heck happened? Much of the volatility centered on the negative trend of the headline metrics. For example, the Q2 revenue print represented a nearly 1% decline on a year-over-year basis. Further, operating income plunged 19.4% against the year-ago period.
Still, there was some positive news to consider. Perhaps the biggest silver lining is a shift in leadership. As TipRanks’ Michael Byrne argued recently, with Michael Fiddelke set to take over as CEO on February 1st, Target has a solid chance of righting the ship.
Still, my argument is that there are many question marks surrounding TGT stock. Therefore, it’s difficult to give a directional take on the security. Instead, for advanced options traders, it may be time to consider going short volatility (while staying Neutral on TGT stock) — especially since the major news items have already been digested.
Explaining the Backdrop of Common Options Strategies
For buy-and-hold investors, the approach is extremely straightforward: you find a publicly traded enterprise you like and you buy its stock, hoping that it rises (or, in other cases, the priority is to collect passive income). However, many folks have grown bored with this approach and have decided to trade options for enhanced leverage and other flexible strategies.
Options as a basic framework are pretty simple. Call options allow holders the right (but not the obligation) to buy the underlying security at the listed strike price. Put options are similar but carry the right to sell the underlying security. While these derivative instruments allow for leveraged bets, they also expire. Thus, great care must be taken when engaging the options market.
Another point about options is that they don’t always have to be bought. Instead, you can sell these derivative instruments, which means you are underwriting the risk that the security will not move as expected by the debit buyer. However, selling options carries the risk of unlimited liability if they’re not covered (in the case of sold calls) or cash-secured (in the case of sold puts).
A popular mechanism to get around the above dilemma is the selling of vertical spreads: they combine a credit-based transaction with a debit-based one. This geometry features a lower net credit received, but at the benefit of capping your maximum potential loss (as the debit side of the spread kicks in at a certain point to cap your liability).
Essentially, the idea is that you can sell an option and enjoy the income generated from the premium collection without having to worry about unlimited liabilities. If the trade goes awry, you’ll know ahead of time what your maximum loss will be. But what happens when you believe that the security will move in a definitive range, but you are unsure about the ultimate direction? In such cases, a short iron condor may be an effective strategy.
A short iron condor combines two vertical spreads: a bear call spread to establish an upside ceiling and a bull put spread to establish a downside floor. You can think of short iron condors as selling volatility. You have a firm conviction that the security will move but in a defined range, and selling a short iron condor allows you to speculate on this belief from the credit side.
I would argue that this is a sensible position over the next few weeks since the volatile event of the Q2 earnings report is in the rearview mirror. Therefore, unless you firmly believe that there will be another exogenous event that will drive TGT stock to either new heights or worrying depths, the digestion has already happened. I think, therefore, that selling a short iron condor may be a prudent strategy for advanced traders.
Breaking Down a Specific Short Iron Condor
According to TipRanks’ expected move calculator, TGT stock is calculated to see a plus/minus swing of $14.19 or a 14.3%. While that’s massive volatility, this calculation is also for the next earnings disclosure. That makes total sense because investors will really want to see Target right the ship during Q3. For that particular options chain, buying a long iron condor could be appropriate.
However, over the next several weeks, I see volatility being more or less contained. In the past 10 weeks, the market voted to buy TGT stock five times and sell five times, all while sparking an upward trajectory during the period. This sequence, which can be labeled 5-5-U, has historically led to a widening of volatility but usually within a range of 12% at the peak.
If we look at the options chain expiring September 19th, I don’t see much movement occurring because the Q2 earnings report has already been priced in and also because past analogs of the 5-5-U sequence don’t imply much kinesis.
With these points factored in, the strategy that is arguably appealing is the 91 | 94 || 103 | 106 short iron condor. This transaction combines the 91/94 bull put spread with the 103/106 bear call spread, for a net premium received of $121. If TGT stock manages to stay at or within the $94 to $103 range at expiration, the credit seller keeps the $121 in full. If the trade fails, the maximum loss is $179.
For this strategy, the risk-reward ratio is 1.48 to 1, meaning that the tail risk if the trade goes awry is manageable. You’ll want to be careful of short positions that carry ratios like 4 to 1, where one bad trade could wipe out the returns of many other transactions in your portfolio.
Is TGT a Good Buy Now?
Turning to Wall Street, TGT stock carries a Hold consensus rating based on eight Buys, 12 Holds, and four Sell ratings. The average TGT stock price target is $105.77, implying ~8% upside potential over the next 12 months.
Profit from Uncertainty in TGT Stock with a Short Iron Condor
Although directional signals by TGT stock may be limited, we’re also dealing with an incontrovertible fact: Target just released its Q2 earnings report. Since that was the major disclosure, much of the wildness of the security has been baked in or digested. As such, volatility over the near term will likely be limited, meaning that selling a short iron condor could be an appropriate strategy.