A risk premium is the additional return an investor expects to receive for taking on extra risk compared to a risk-free investment, such as a government bond. It represents the compensation for bearing uncertainty or potential losses associated with an investment. For stock market investors, the equity risk premium is the theoretical excess return of stocks over risk-free assets to account for market risk. Theoretically, the greater the risk, the greater the premium. In the case of Target , investors are pricing in a significant equity and volatility risk premium not only above risk-free investments, but also against their competition. Target is trading at just 11 times forward earnings. That’s one-third the valuation of Walmart, and its three-month implied volatility is roughly double that of its bigger rival. The chart below shows a time series of 4-week realized volatility for Target over the past five years. The yellow arrows indicate the company’s quarterly earnings announcement dates. Two things are immediately apparent: Target’s 4-week volatility is much greater during periods when it announces earnings than it is in others. The volatility the stock exhibits when it announces isn’t consistent, but bigger price movements appear more frequently in recent quarters (left side of the chart). Target revenues have climbed by more than 36% over the past five years. Earnings, which peaked three years ago, have since fallen — but are also about 24% higher than five years ago, yet the company’s valuation is considerably lower. The contrast between Target’s and Walmart’s performance over the past five years is stark. Walmart’s total return is around 150%, outperforming both the S & P 500 consumer discretionary sector, while Target’s is down 10%. There is one metric where Target has grown relative to Walmart: retail square footage. Walmart’s footprint peaked several years ago and is about 9% below its all-time high, during which Target’s square footage grew by 3.7%. Target has closed several locations due to sharp spikes in crime/retail theft in recent years. The company also trimmed a smaller percentage of underperforming locations than Walmart has. Another key difference is that Target has focused less on groceries than Walmart, which is a big draw for repeat business. From an operational perspective, this could provide a bright side. Target could start taking cues from its larger rival, using it as a template for a turnaround. The stock recently filled a gap that dates back to the company’s August 2019 earnings release. Betting on a fortune reversal is a contrarian bet. How contrarian? Only 36% of the analysts covering the stock have a “buy” rating, which ranks in the bottom quartile of all large-cap stocks in the Russell 1000. Distressed retailers often struggle to regain their footing. In Target’s case, its balance sheet gives it some time. The trade: Calendar spread One way to make a bullish bet while risking somewhat less capital than buying the stock is with a calendar spread. In the example below, purchasing a longer-dated call is financed by selling a nearer-dated strangle. This trade would require an outlay of around $2.73 per share. It also involves the risk of being compelled to purchase the stock at the short $84 put strike (closer to $87 a share when one factors in the premium spent on the strategy). However, that does represent a ~ $10 discount to the current stock price in the worst case. If the stock trades sideways out of earnings, the trade should profit from the “vol crush” and, of course, will profit if the stock rallies on better-than-expected news. Here’s the trade structure laid out: Buy 1 Sept. 19 110 call ($5.73 premium) Sell 1 June 27 115 call ($1.51 premium) Sell 1 June 27 84 put ($1.49 premium) Make no mistake, Target has its work cut out. Foot traffic (according to Placer.ai data) has been weak, and the company needs to make some changes to remain relevant, but their more successful rivals have given them the steps to follow. DISCLOSURES: None. All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
