Patient in a Pairs Trade of JCP / KSS

by Jay Pestrichelli on February 24th, 2012

About a month ago, one of our clients called us with an idea that JC Penny was overvalued and wanted to see if we could make a play on it to the down side. Don’t get me wrong, overall, he was bullish on the market and thought that the newly named CEO would be able to eventually turn around the company, but his thesis was that the market reacted too quickly to the anticipated changes.

For those of you not following the story, in October 2011, JCP hired Ron Johnson, former guru that engineered Apple (AAPL) to arguably one of the greatest retailers in history. When the company announced that it was revamping its brand and would roll out a new pricing strategy at an investors meeting on Jan 26th, JCP stock shot up from 34 to 41 a share in a single day.

He also stated at that time the company would handle this transformation without borrowing and would fund the transformation with cash flows from operations. See the WSJ article here titled: Penny CEO Says Profit Won’t Suffer. All of this led traders and investors to make a notable play in the markets.

Let’s get back to the trade. Since we were bearish in the mid-term time frame, we wanted to be efficient with our cash and not tie too much up, so we decided to use options. Add to that the market in general was in a bullish run, we wanted to pair it up as an offset. Meaning that we were really playing an underperformance vs. a straight bearish move. Creating a pairs trade would allow us to profit if the stock moved up less relative to the sector or a different stock.

We picked Kohl’s (KSS) as the a stock that we theorized would outperform for two reasons. First, it had been doing well in same store sales but had not participated in the industry’s rebound, so we thought it was due to catch up. Second, and most importantly, KSS has historically moved with a high correlation to JCP. The recent moves of both companies had put them significantly out of alignment and any reversion back to the mean would yield a profit.

So on Jan 31st, we put a bear put spread with strikes 36/47 on JCP with and a bull call spread on KSS with strikes of 41/52. The trade costs us about $10k and if we were right on both symbols would be worth $20k. Because we used a pair, we assessed we would only hit the max loss on one of these so our true risk was closer to $5k. As we decided to go mid-term the July and August expiration periods were chosen.

Fast forward to earnings yesterday morning 2/23. Kohl’s, that had made a nice run from 46 to 52 in the last month, announced disappointing results for Q4. The stock took a beating yesterday to the tune of about 6% and pulled back to 49. Still in our profit range, but it certainly stung a little.

Add to that this morning, 2/24, JCP announced a loss of $87 million or a 0.41 loss per share compared to $1.13 earlier the previous year. See summaries here from FT Press and Wall St Cheat Sheet.

One would have thought that this would have been good news for our bear trade., but alas, the position has only moved down marginally as of the first hour of trading holding between 42 and 41. As it turns out, our trade will have to wait longer to hit our profit goals. We’re not at a loss, but we’re not cashing the register either. The total trade as of this morning was profitable to the tune of about $700, but earlier in the week it was good as $2k.

Two lessons to report here:

Lesson #1: We’re glad to be hedged. It’s why it’s the #1 rule in our book, Buy and Hedge. Things may not go as you want them to go, and being hedged sure helped us in two ways. Our downside on both trades was limited AND we use a pairs trade to offset the broader market momentum.

Lesson #2: Its tough to be a contrarian and fight the tape. As we’re seeing, it can take time to get this kind of trade right. Clearly the investor community is still smitten with Ron Johnson’s plan and certainly holding up the market. The Apple loyalty has a halo effect and despite losing money in Q4 due to one-time charges (which from the description in the article, don’t really seem like one-time charges to me), JCP holds its price. So when fighting the market momentum of both of these stocks, we’re glad to have given it enough time to work.

Bottom line: We’re going to stay patient in this trade for another quarter, and use the time we afforded ourselves in the first place.

Happy Hedging!

Go an idea for a pairs trade? Reach out to us or post a comment to this story, and we’ll take a look and you may see it on the blog!

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