J.C. Penney: Is The New ‘Fair And Square’ Policy A Death Knell?

Published on: Jul 10 2012 by John Critchley

More bad news for the American retailing icon, J.C. Penney (JCP). J.C. Penney is continuing its death spiral (-3.95%) after analysts at Credit Suisse lowered numbers for the one of the largest department store chains in the United States. Analyst Michael Exstein says that sales at the retailer are lagging the dismal first quarter numbers.  In May, J.C..Penney announced store sales fell 20 percent from last year and for the company to underperform these numbers in upcoming quarters is spooking investors today.

This downgrade comes just a few weeks after the unexpected shakeup in its executive suite which caused shares of J.C. Penney slide to a two-year low following the resignation of president, Michael Francis. (Source: Click Here)

This is in stark contrast to the ebullient reaction to the hiring of Ron Johnson as the new CEO in January. Investors embraced J.C. Penney’s new leader, the architect of the reinvention of Target and retail guru at Apple and lifted the shares 23% to $40.72 on that day in January, on 10X greater than normal volume of nearly 47 million shares.

Johnson’s initial strategy at J.C. Penney was to replace the store’s dependency on special discounts (hundreds of sales in 2011) with a “fixed and square” policy where prices start 40% lower and remain there.

So far, the strategy appears to be a colossal failure and for the last month, many financial pundits have been kicking sand on Ron Johnson’s grave. Whether or not this strategy succeeds in the long run is anyone’s guess, but the surging implied volatility in J.C. Penney options present an opportunity to take advantage of these elevated premiums to express a directional view.

Options Plays

With J.C. Penney’s collapse following recent events and continued weakness, the 30 day implied volatility of the options is quite elevated. The 30 day implied volatility is trading around 60.90%, significantly higher than the 52 week implied volatility low of 30.88% hit in March of this year.

Let’s take advantage of these elevated implied volatilities to either initiate a brand new short position or to speculate on a bullish turnaround in J.C. Penney.

Trade idea #1 -A Bearish Options Play

If you believe this may be an opportune time to initiate a bearish position, the elevated implied volatility across the board in J.C. Penney options creates opportunities in the options marketplace through some put plays.

To take advantage of abnormally elevated downside implied volatility skew and to benefit from any further downward pressure in the stock in the next month, let’s go out to the AUG 18th ’12 options. With earnings tentatively set to be released on August 8th, the purchase of these August options allows us to also participate in any post earnings underlying activity.

The play:

a) Buy August 18th ’12 22-17 put spread for $ 1.68 Receiving about 12.81% in implied volatility skew ( buying 63.23 IV vs. selling 76.04 IV)

To finance this spread:

b) Let’s sell the August 18th ’12 24 calls for $ .74 This is approximately a 61.3% Implied Volatility.

Net debit: $.94

Why sell the August 24 line? Two main reasons:

1) There is a group of investors that believe in the J.C. Penney turnaround story and therefore the upside call options are still quite bid. By selling the August 24 line at 61.3% IV, you are only giving up a 1.43% discount to the August 22 puts. Normally, one would see a more pronounced skew (difference) between the OTM calls and puts. Let’s take advantage of this anomaly.

2) If your view turns out to be faulty, you still may be able to get away with being short some upside calls as you only start to incur losses if the underlying rallies nearly 13% between now and August 18th ’22 expiration.

Risk: You will be Short the stock over $24. A 13 % upward move in J.C. Penney over the next month.

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