Traders Could Make 30% on a Former High-Flier That Has Further to Fall

Stock prices generally reflect expectations for the future. If investors believe earnings will grow, stock prices can soar, and they can fall just as quickly if earnings disappoint. The yearly chart of Hot Topic (NASDAQ: HOTT) shows what this type of price action looks like.

HOTT Chart

HOTT defied the general market trend in 2000, and delivered gains of more than 2,800% during one of the worst bear markets in history. Then, the company disappointed investors and the share price came back down to Earth.

#-ad_banner-#

Over the past five years, HOTT has been struggling and earnings declined an average of almost 12% a year over the past five years. Analysts are now expecting a turnaround and looking for earnings per share (EPS) growth to average 26% a year for the next five years.

On a fundamental basis, the stock seems fairly valued. Analysts are looking for EPS of $0.51 for the 12 months ending January 2014. If HOTT trades at 20 times those earnings, the stock would be worth about $10 a share, only a few cents above the recent price.

Time will tell if the analysts are correct, but the current stock price gives HOTT little room for error. The stock is trading at a price-to-earnings (P/E) ratio of 26, which is above next year’s expected earnings growth rate of 21%. While the P/E ratio might be justified by the long-term growth rate, traders may react to disappointing numbers from HOTT by selling the stock.

HOTT could very possibly disappoint investors again, like it has repeatedly in the past 10 years. In the third quarter, the most recent data available, the company reported that same-store sales grew only 0.2%. Same-store sales are used by retailers to measure their growth, and HOTT is lagging its competitors in this measure.

A competitor in the teen-focused fashion sector, Zumiez (NASDAQ: ZUMZ), reported same-store sales growth of 3.7% in the same quarter. Teen fashions can change quickly, and if HOTT was not keeping up with the trends in the third quarter, the fourth quarter, which is a very important season for retailers, might be difficult.

The weekly chart shows that HOTT could be vulnerable to a sell-off. Prices are near the upper Bollinger Band, which could offer resistance, and the stochastics indicator is overbought and appears ready to give a sell signal. A move toward the lower Bollinger Band would be expected from this level offering traders a price target of about $8.35.

HOTT Chart

To take advantage of this trade setup, traders could buy February $9 put options, which are trading at about $0.48. HOTT will be releasing information about holiday sales in early January, and full fourth-quarter sales results in early February. February options will provide exposure to both of these news releases, and if sales are slow, the stock could fall sharply.

If HOTT falls to $8.35, then the options would be worth at least $0.65. If HOTT disappoints, selling could accelerate and push the price even lower.

Small wins could add significant equity to a trader’s account. Risk can be limited if the trade can be entered with a small amount of capital. This trade offers significant gains, on a percentage basis, and several options contracts could be bought with a relatively small amount of trading capital.

Recommended Trade Setup:

— Buy HOTT Feb 9 Puts at $0.50 or less
— Set stop-loss at $0.25
— Set price target at $0.65 for a potential 30% gain in 10 weeks