• Bocconi Students Options Club

Target: Call Bull Spread

DISCLAIMER:

This association and its publications are solely intended for academic purposes and should not be used as investment advice or be interpreted as such.


Play: Call Bull Spread

Maturity: 15th January 2021


The Company

Target Corporation (NYSE:TGT) is a retail corporation, focusing on general consumer goods ranging from food, to apparel, to electronics. The corporation itself was founded under the name “Dayton-Hudson Corporation” in 1902, in Minneapolis. In 1962, the corporation began opening retail locations named “Target” in the United States, leading to the change in name to Target Corporation in 2000.


Today, Target is truly one of the largest corporations in the United States; ranked 38th on the Fortune 500 (2020) and being a component in the S&P 500 and S&P 100 indexes. Additionally, Target is considered to be the 8th-largest retailer by revenue (FY2017: $71.879b) in the United States, maintaining a total market share in U.S. retail between 2% and 3%. In addition to 1,900 stores nationwide (stores available in all 50 states), Target is also a leading online retailer through their e-commerce platform: target.com. Overall, Target employs around 359,000 individuals, mostly in the United States, but also in sourcing offices found in South-East Asia and Central America.


Target is able to differentiate itself from competitors in its philosophy, with their “purpose” being: “To help all families discover the joy of everyday life”. The corporation commits to this purpose through various programs; namely, giving 5% of their annual profits, volunteering 1 million+ hours for community service or being one of the top corporations in terms of equality/inclusivity.


Fundamental Analysis

Activities and Outlook

After a notorious, failed expansion campaign for the subsidiary Target Canada (defunct 2015), the corporation continues to serve exclusively in the United States. In the last 15 years, Target continues a trend of growth by approximately 36 new stores and 4,500 new employees annually. Financially, these aspects translate to a $1.9b growth in revenue and $600m growth in total assets annually (FY2005-2019). According to German database firm Statista, these trends of growth will continue with an appx. $10b growth in annual revenue by 2025.


In recent years, Target has opted for vertical integration strategies; acquiring firms in their direct supply chain, in order to decrease costs and increase efficiency. Namely, in the last 3 years, Target has acquired the firms Shipt, Deliv and Grand Junction of the delivery/transport sector, which have/are due to aid Target’s physical supply of certain goods and also delivery services, and thus could allow them to better compete with Walmart and Amazon.


Fundamentals

Analyzing the key up to date ratios of Target clearly demonstrates its strong financial position within the retail industry. Evidently, they are able to clear debts faster than the industry average with a quick ratio of 0.21 vs. 0.16 whilst simultaneously generating a higher profit with its elevated net profit margin of 4.2% vs. 2.4%. The EV/EBITDA industry average is slightly skewed due to poor performance from The Chefs Warehouse (-300.94).


Industry trends and dynamics

The shift from in-store retail to online shopping has been a general trend affecting all retail businesses. Target had initially created a strategic three-year plan to incorporate a more wholesome and dynamic online shopping experience, but with the onset of COVID, this plan has been implemented in a matter of weeks.


The retail market is dominated by a few key firms, holding steady market share positions, each with their own niche. Target typically appeals to customers who enjoy higher incomes by emphasizing high-quality merchandise and low-cost designer fashion. Walmart's emphasis on low prices typically draws shoppers with lower household incomes. Costco shoppers are often affluent, suffering less direct impact from a general market recession than Target and Walmart customers. The leader of the market is Walmart, who possesses an annual revenue nearly 7 times greater than Target, and approximately a 16% total market share.


Target achieved an online sales growth of 155% in Q3 2020, and the average online sales value for any given day in April 2020 was higher than previous Cyber Mondays. This demonstrates the enormous pressure that has been put on retailers, severely straining their supply chains and increasing costs for physical stores. To cope with this explosive demand, Target has converted stores into sorting centers and partnered with Deliv, with the aim of aiding their “last mile delivery” which has proven to be the costliest in the distribution process.


The remoteness and impersonality of online shopping have led to retailers experimenting with new techniques to increase customer interaction and purchasing values by offering same-day pickup in-store. According to Target CFO, Michael Fiddelke, “When customers use the retailer’s curbside pickup service, for example, they spend more at Target — not just online, but in stores”. This interaction and customer engagement not only increases purchases but also increases Target’s relevance, which is key in the online race.


Motivation

With the Covid pandemic far from over, and rolling lockdowns across the continental US, the importance of quick and seamless e-commerce and delivery options are crucial to increase sales. Target has anticipated this and has boosted its e-commerce capabilities to support the expected high volumes with Order Pick Up (BOPIS), Drive Up (curbside pickup), and Shipt to fulfill its digital orders. This puts Target in a unique position for the Christmas shopping season, a typically great period for retailers, and we expect that Target’s stock price, currently at 171.24$, will climb, possibly breaching its all-time-high of 181.11$. A bull spread would effectively take advantage of Target's stock price momentum in the coming weeks.


According to CNN Business, 24 analysts offering 12-month price forecasts for Target Corp have a median target of 190.00, with a high estimate of 212.00 and a low estimate of 151.00. The median estimate represents a +11.74% increase from the last price of 170.04.


Technical Analysis

In this section I will demonstrate how the technicals regarding Target’s past prices are showing bullish trends.

The analysis will employ both overlays and oscillators to get a clearer picture of the identifiable trend.


The chart above shows Target’s price movements in the upper half since July of this year, together with trend lines, moving averages and a separate Moving Average Convergence Divergence (MACD) indicator on the bottom half.


The upward longer-term trend beginning roughly in July shows a lot of promise in both the upper and lower trend lines, indicated in blue, as both the support on the lower one and the resistance on the upper one have been tested around 3 times, with the last support happening in the past week. They seem to be forming a rising wedge, where the two upward trend lines are converging slowly. The trend indicates that the price will continue to move upwards towards the resistance level of the upper line at around 190 and should reach it within a month. Furthermore, since that trend line has been tested multiple times there is a high chance it may break through this time, indicating even further upside.


The recent shorter-term downward trend indicated by the yellow lines, where both the support and resistance have been tested multiple times, have been broken on the upward trend line, indicating further future gains.


The price pulled back slightly recently, but the higher low at the moment is above October high, shown by the dashed white line, and seems to be turning around, indicating an upwards trend and an ideal place to get in for a long position.


Both the 30- and 60-day Exponential Moving Averages (EMA) show fast and tight patterns, indicating that buyers are in control. The 30-day EMA has been approached and tested as well since the start of the trend in July-August, but has remained strong, indicating a strong, persistent bullish trend. The analysis relies on exponential moving averages instead of simple moving averages as EMAs are more responsive to price changes, since they use larger weights for more recent prices. They provide a clearer trend than their simple counterparts.


The Moving Average Convergence Divergence (MACD), which helps identify trend direction as well as momentum, shown on the bottom graph with the blue line, indicates that the price is in an upward trend, while it is also close to crossing the slower signal line, shown in orange, indicating a good place to buy.


Overall, the technical indicators outlined above present a bullish view on Target, which coupled with our fundamental analysis that reaches a similar conclusion leads us to advise on taking a long position in Target. Target seems to be about to hit a resistance point and to move north in the short term which fits perfectly with our strategy.


The Options Play

The Structure/Strategy

As indicated above, our team is feeling bullish on Target Corporation stock by the December holiday season. Because of this line of thought, we decided to commit to a bull spread as our trading strategy. As a quick overview, a bull spread is a bullish option strategy meant to let the investor profit from a modest increase in the price of an underlying asset. It utilizes the concurrent purchase and sale of put/call options with the same underlying asset and expiration date but different strike prices.

A bull spread can be performed using both put and call options. A call spread normally results in a higher maximum profit and a higher maximum loss for an investor, while the put spread offers a lower break-even point.

All things considered, our team believes the bull call spread is the most suitable strategy given our outlook. Our trading structure will involve writing a call option with a strike higher than the current market in long calls, while concurrently buying a call with an identical expiration at a lower strike price. The trade will require an initial cash outlay unlike the put spread, which initially generates net credit to the account.

With a short-term focus, we will purchase TGT call 175.00 at a price of 4.95 (expiring 01/15), while simultaneously selling a TGT call 180.00 at 2.77.


Break-even Point

Our breakeven at maturity is calculated as follows:

175 + 4.95 – 2.77 = $177.18

We therefore need TGT to rise about 1.2% or more to breakeven which seems attainable and realistic based on fundamentals, technical and market momentum.


Max Profit of the Strategy

Since option contracts correspond to 100 shares of the underlying asset, the initial net outlay from operating with each call contract will be:

- (4.95 * 100) – (2.77 * 100) = 495 – 277 = 2181

A positive net outlay implies that the investor’s account is initially debited. This is why bull call spreads are often referred to as “debit call spreads”.

The maximum profit for the investor will occur if both aforementioned contracts are in the money. This of course will only happen if TGT spot price exceeds both strike prices discussed above. Assuming an optimistic bump of 2.8% over the holiday season, TGT will be trading at roughly $185.00. This would lead to both the long and the short call legs to be in the money by $5 and $10 respectively. The scenario would lead to the following profit:

- (10 – 5) * 100 – net outlay = 500 – 218 = 282

In this optimal case a return of 129% would be made on the initial investment of $218.


Max Loss of the Strategy

In the pessimistic scenario that TGT spot price at expiration falls below both our strikes of 175.00 and 180.00, both contracts will be out of the money and lose value, thus the net loss made will be equal to the initial net outlay:

- 0 – 218 = -218

Accounting for commissions, the loss will be slightly higher in a realistic scenario.


The Cost of the Strategy

The price of the trade will simply be the commission cost added to the initial net outlay in the account.

- $218 + Commissions Paid


The Pros of the Strategy

The bull call spread offers the trader a quantified amount of maximum potential loss ex-ante. This quality is valuable for individual traders that do not have the resource to afford potentially unlimited losses.

The call spread is a heavily customizable strategy. Risk-lovers can opt for a wider spread between the two strikes, while more conservative traders are able to minimize this difference. It is possible to heavily control the risk profile of one’s portfolio utilizing the personalizable nature of the bull spread.

Moreover although this is a risky strategy, a potential of 100%+ returns for only a slight increase in the underlying stock TGT is very rewarding for the trader and strengthens our view for this position.


The Cons of the Strategy

The returns of a bull spread have a limited scope and are rapidly “capped” if price movement surpasses the short call’s strike (180). It is best to exercise the strategy in moderately bullish markets rather than areas where large booms are to be expected. In significant price rises, the bull spread is heavily outperformed by other trading structures.

The bull call spread also puts the investor under the risk of the short call buyer exercising their option, thus the trader is in turn obliged to exercise the long call and deliver the security. The time discrepancy may lead to an assignment mismatch. The early assignment risk is particularly important as a small position could virtually increase to over $15,000 worth of involvement at a moment- margin accounts or large accounts offer safety to this assignment risk which might not negatively impact your P/L for the trade but could affect your portfolio’s liquidity.