Investors in leading retailer Target (NYSE:TGT) have enjoyed solid gains so far in 2021. TGT stock, which trades around $254, is up 43.9% year-to-date, and 60.5% in the past 12 months. In the past month alone, shares returned more than 10%.
The 52-week range for TGT stock has been between $154.75 (Nov. 9. 2020) and $267.06 (Aug. 11, 2021). The current price supports a dividend yield of 1.42%, and the company’s market capitalization exceeds $123.9 billion.
Target issued robust Q2 results Aug. 18. Total revenue was $25.16 billion, up 9.5% year-over-year. The retailer reports metrics in five categories: apparel, food and beverage, essentials and beauty, home, and hardlines. Sales grew in each of the five segments.
Adjusted earnings per share (EPS) were $3.64, up 7.9% compared with last year. Meanwhile, comparable sales grew 8.9%. Analysts pay attention to this metric as it measures sales both online and in stores open at least a year. In the second half of 2021, management forecasts comparable sales to increase by high single digits.
On the results, CEO Brian Cornell said:
"In the second quarter, our business generated continued growth on top of record increases a year ago, reinforcing Target's leadership position in retail. We've spent years building and investing in the durable model we have today.”
Next Move In TGT Stock?
Among 30 analysts polled via Investing.com, Target shares have an “outperform” rating, with an average 12-month price target of $271.80. Such a move would imply an increase of more than 7% from the current level. The target range is between $317 and $70.33.
Chart: Investing.com
Put another way, despite the impressive run-up in price in 2021, Wall Street expects Target to keep creating shareholder value. But we should remind readers that management will release third-quarter numbers Nov. 17 before the market open. Therefore, there could be increased choppiness in TGT shares between now and then.
Although investors might want to buy TGT stock for their long-term portfolios, they could also be nervous about potential profit-taking in coming weeks. Therefore, some might prefer to put together a "poor person's covered call" on the stock instead.
So, today we introduce a diagonal debit spread on Target by using LEAPS options, where both the profit potential and the risk are limited. Such a strategy could be used to replicate a covered call position at a considerably lower cost and help decrease portfolio volatility.
Investors who are new to the strategy might want to revisit our previous articles on LEAPS options first (for example, here and here) before reading further.
Diagonal Debit Spread On TGT Stock
Price at time of writing: $253.95
A trader first buys a longer-term call with a lower strike price. At the same time, the trader sells a shorter-term call with a higher strike price, creating a long diagonal spread.
Thus, the call options for the underlying stock have different strikes and different expiration dates. The trader goes long one option and shorts the other to make a diagonal spread.
In this strategy, both the profit potential and risk are limited. The trader establishes the position for a net debit (or cost). The net debit represents the maximum loss.
Most traders entering such a strategy would be mildly bullish on the underlying security. Instead of buying 100 shares of TGT, the trader would purchase a deep-in-the-money LEAPS call option, where that LEAPS call acts as a “surrogate” for owning the stock.
For the first leg of this strategy, the trader might buy a deep in-the-money (ITM) LEAPS call, like the TGT 19 Jan. 2024, 190-strike call option. This option is currently offered at $74.85. It would cost the trader $7,485 to own this call option, which expires in about two years and two months, instead of $25,395 to buy the 100 shares outright.
The delta of this option is close to 80. Delta shows the amount an option’s price is expected to move based on a $1 change in the underlying security.
If Target stock goes up $1 to $254.95, the current option price of $74.85 would be expected to increase by approximately 80 cents, based on a delta of 80. However, the actual change might be slightly more or less depending on several other factors that are beyond the scope of this article.
For the second leg of this strategy, the trader sells a slightly out-of-the-money (OTM) short-term call, like the TGT 21 Jan 2022 260-strike call option. This option’s current premium is $9.65. The option seller would receive $965, excluding trading commissions.
There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point. Different brokers might offer “profit-and-loss calculators” for such a trade setup.
Calculating the value of the back-month option (i.e., LEAPS call) when the front-month (i.e., the shorter-dated) call option expires requires a pricing model to get a “guesstimate” for a break-even point.
Maximum Profit Potential
The maximum potential is realized if the stock price is equal to the strike price of the short call on its expiration date. So the trader wants the TGT stock price to remain as close to the strike price of the short option (i.e., $260) as possible at expiration (on Jan. 21, 2022), without going above it.
Here, the maximum return, in theory, would be about $1,386 at a price of $260 at expiry, excluding trading commissions and costs. (We arrived at this value using an options profit-and-loss calculator). Without the use of such a calculator, we could also arrive at an approximate dollar value. Let’s take a look:
The option seller (i.e., the trader) received $965 for the sold option. Meanwhile, the underlying TGT stock increased from $253.95 to $260, a difference of $6.05 per share, or $605 for 100 shares.
Because the delta of the long LEAPS option is taken as 80, the value of the long option will, in theory, increase by $605 X 0.8 = $484.
However, in practice, it might be more or less than this value. There is, for example, the element of time decay that would decrease the price of the option. Meanwhile, changes in volatility could increase or decrease the option price as well.
The total of $965 and $484 comes to $1,449. Although it is not the same as $1,386, we can regard it as an acceptable approximate value.
Understandably, if the strike price of our long option had been different (i.e., not $190.00), its delta would have been different, too. Then, we would need to use that delta value to arrive at the approximate final profit or loss value.
Here, by not investing $25,395 initially in 100 shares of Target, the trader’s potential return is leveraged.
Ideally, the trader hopes the short call will expire out-of-the money, or worthless. Then, the trader can sell one call after the other, until the long LEAPS call expires in about two years and three months.
Bottom Line On TGT Stock
We regard Target stock to be a solid long-term choice for most retail portfolios. However, the upcoming earnings results might mean choppiness in TGT shares. Therefore, this example of a trading strategy could help decrease portfolio volatility.