As the market made new highs over the past six years, many companies could seemingly do no wrong. Investors rushed into highfliers as enthusiasm trumped reason, driving prices even higher.
When enthusiasm begins to crumble, though, as it has in the recent market sell-off, these investor favorites are typically some of the hardest hit. Luckily, due to their high levels of volatility, they can be even more profitable on the way down and offer a hedge against market weakness in your overall portfolio.
To that end, one once-soaring stock –which boasts a valuation more than five times that of the S&P 500 — may be headed for a big drop that traders can leverage into 25% profits.[ad#Google Adsense 336×280-IA]Shares of Under Armour (NYSE: UA) have rocketed more than 1,500% over the past six years as the apparel company posted strong growth, added new products such as footwear and accessories, and took market share from larger rivals.
After the huge run up, shares trade for an unbelievable 103 times trailing earnings.
And there are numerous risks beyond its sky-high valuation.
For starters, the company is aggressively expanding — both internationally and through new products like its line of apparel-connected systems.
The expansion is eating into profitability, while strength in the U.S. dollar is weighing on foreign sales. Operating margins sank to just 4.1% in the second quarter, down from 5.7% a year ago, as higher marketing spending and materials costs ate into profits.
Under Armour is prone to supply chain risk as well. About two-thirds of the fabric used in the company’s products comes from just five suppliers in Taiwan, Singapore, Mexico and El Salvador. Meanwhile, nearly all of the company’s products are manufactured by unaffiliated manufacturers, leaving Under Armour little control over production.
Just 10 manufacturing partners account for 52% of production, and two-thirds of manufacturing takes place in China, Jordan, Vietnam and Indonesia. This makes Under Armour especially vulnerable to any civil disturbances in these countries.
Finally, slowing economic growth and currency volatility have already heightened global risk, especially in emerging markets. For instance, annual inflation of 7.6% and the slowest economic growth in five years have led to massive worker protests in Indonesia this year.
So it’s not surprising shares plunged when the market suffered its first real correction in nearly four years. But while the S&P 500 dropped 10% in four days, UA was hit with a 20% loss.
The high volatility in the stock, coupled with fundamental risks and an unrealistic valuation, makes UA a great candidate to hedge overall market weakness. I believe further weakness in the market or any of the previously mentioned company-specific risks could send shares back to at least their recent closing low near $85.
That target is 11% below the current price, but using a put option strategy, we can leverage that move into a 25% profit that could help offset weakness in other areas of our portfolios.
With UA trading for $95.63 at the time of this writing, we can buy Jan 2016 97.50 Puts for around $10 per share. That is a put option with a $97.50 strike price that expires on Jan. 15. Each contract controls 100 shares, costing you $1,000 per contract.
The trade breaks even at $87.50 ($97.50 strike price minus $10 options premium), which is 8.5% below the current price.
If UA hits my $85 price target by expiration, the option will be worth at least $12.50 ($97.50 strike price minus $85 stock price) for a 25% return in four and a half months. Place a good ’til cancelled (GTC) order to exit at this price.
With the downside potential for UA high, we may end up hitting our target long before expiration. In addition to the bearish catalysts discussed above, the company is scheduled to report quarterly earnings in late October, and I think analysts’ estimate for 25% sales growth is overly optimistic.
Under Armour is far from the only popular stock that is likely to get hit. One expert is predicting the worst is still to come, and traders would do well to listen since he predicted the current correction in early July while others stuck their heads in the sand.
— Joseph Hogue
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Source: Profitable Trading