This Stock Looks Set to Break Out

During the past four years, there is a well-known retailer whose stock has gained more than 22,000%, but is still not on the potential buy list of many traders. I think that will change soon.

Traders often turn their attention to retailers as the end of the year approaches, and a stock with a record like Pier 1 Imports (NYSE: PIR) is sure to attract some attention. The chart shows that it is forming a base and we could see PIR build on those large gains before the year-end.

[ad#Google Adsense 336×280-IA]Pier 1 Imports operates about 1,000 stores offering furniture and other household items.

During the past five years, earnings per share (EPS) have grown at an average rate of about 25%, and analysts expect EPS growth of about 20% in the next five years.

Based on its earnings, PIR appears to be undervalued.

The stock is trading at a price-to-earnings (P/E) ratio of about 12 based on the EPS for the past 12 months and about 14 based on projected earnings.

Many analysts believe that a stock is trading at fair value when the P/E ratio is equal to the EPS growth rate. With forecasted growth of 18% next year, PIR would have a fair value of about $24.85 under that model, nearly 28% above the current price.

The chart below shows this stock could be a buy on a breakout from a short-term consolidation pattern.

PIR has been in a steady uptrend since bottoming at $0.10 a share in 2009, and is now nearing the completion of a possible cup-and-handle chart pattern. The shaded area in the chart above shows that PIR has not decisively broken out to the upside in the past few weeks, and traders can minimize risk by waiting for that breakout, which would occur at about $20.80.

Once a breakout is completed, I think momentum traders will start buying and push the price higher. The pattern offers a price target of $22.10, about 6% above the breakout. A confirmed down move would not occur until the price fell back to the middle of the pattern, at about $17. That represents a possible risk of 18%, or three times the potential gain. Rather than trading the stock, options on PIR could offer a way to tilt the reward-to-risk ratio in favor of the trader.

Call options offer a way to increase the size of the potential gain while maintaining an acceptable level of risk. December $20 calls are trading at about $0.75. Breakeven on the position is just below the resistance level, and when a price moves through resistance, it is common to see the move accelerate. At the price target, the calls would be worth at least $2.10, a potential gain of 180%. The risk is limited to the price paid for the option, although a stop-loss can be used to limit risk further.

We could also see gains in PIR based on improving industry trends and increased holiday sales. According to Barron’s, the National Retail Federation expects spending to rise 4.1% in November and December compared with last year. Consumers have been optimistic with the University of Michigan consumer sentiment survey recently reaching a five-year high.

December options expire at the close of trading on Dec. 21, and PIR is scheduled to release earnings on Dec. 10. The price of the stock could see a significant move based on that announcement. With a potential price-moving event expected before the expiration date, these options seem like a way to profit if the report is positive.

Recommended Trade Setup:

— Buy PIR Dec 20 Calls at $1.05 or less
— Set stop-loss at $0.50, which should limit the risk to no more than $55 per contract
— Set price target at $2.10 for a potential 100%-plus gain in six weeks

— Amber Hestla-Barnhart


Source: TradingAuthority