Exploit This Stock's Pending Collapse for 70% Potential Profits

Thirty years ago, kids couldn't get enough of their favorite toys. From GI Joe to Cabbage Patch Kids to Speak & Spell, the American-made toy offered a quality, visceral experience that empowered kids to explore their imaginations.

Today, most of the games that children over age 6 play with are either on smartphones or gaming console. Sure, kids still have Barbie and Hot Wheels, but traditional toymakers are fighting tooth and nail to grow while software companies are reaping billions in profits.

According to a recent study by Common Sense Media, in 2013, 38% of kids under the age of 2 (yes, 2) used a smart device to watch video, play games or engage in other media. That number jumps to 72% for kids under age 8. And the average amount of time spent on these devices per day has tripled in the past two years from five minutes in 2011 to 15 minutes in 2013.

Mattel's (NASDAQ: MAT) earnings struggles are a testament to this trend as the company struggles to maintain its relevancy and profit growth in this highly competitive industry.

Following a disappointing holiday season that saw weaker-than-expected sales of its Barbie, Hot Wheels and Fisher-Price toys, Mattel's fourth-quarter revenue and earnings missed expectations.

In April, the toymaker reported first-quarter sales were down 5% compared to last year, with North American sales off 2% and international sales declining 7%. Worse still was the sizable drop in operating income. MAT earned just $6.2 million compared to $65.8 million in the first quarter of 2013. This netted the company a loss of $0.03 per share versus prior-year EPS of $0.11.

A strengthening U.S. dollar added a modicum of pain to MAT's balance sheet, and I'd expect that trend to continue as we move toward higher interest rates.

Mattel is working hard to get back on its feet as global inventories remain high and distributors order less. The company did announce the acquisition of Canadian toymaker Mega Brands in March, as well as the launch of BOOMco, its foray into the outdoor games category, but I don't see these ventures having a significant impact in the near term.

Mattel is also fighting to get children engaged digitally, but remember that most apps are free or extremely cheap, and the company hasn't quite found a way to monetize that media efficiently. Unless Mattel buys an established software or gaming company, it will take time for it to return to real relevancy, let alone serious growth.

In addition to the fundamental struggles, MAT is on the precipice of a big move that will likely be lower. 

MAT Stock Chart

Note the large gap lower in late January on the fourth-quarter earnings miss. The stock failed to fill the gap and peaked in early April around the $40 level, kicking off a series of lower highs and the subsequent wedge formation. The wedge's lower highs and higher lows bring us to a breaking point right around the 20-day and 50-day moving averages, near the $39 mark.

The weakness in the broader market likely helped motivate a failure at the 50-day moving average, which should result in a further breakdown to the $35 level.

MAT Put Option Trade

Today, I am interested in buying MAT Oct 40 Puts for a limit price of $2.95.

MAT Put Option
Risk graph courtesy of tradeMONSTER

This put option has a delta of 64, which means it will move roughly $0.64 for every dollar that MAT moves, but it costs less than one-tenth the price of the stock.

The trade breaks even at $37.05 ($40 strike price minus $2.95 options premium), which is 3.5% below current prices.

I am looking for MAT to make a quick move lower to $35 over the next two months, which would equate to at least $5 in the option, and that is where we will place our target.

For our stop-loss, we are going to use the 200-day moving average (MA), currently at $41.75, as a trend monitor. If MAT closes above its 200-day MA for two days, exit the position.  

Recommended Trade Setup:

-- Buy MAT Oct 40 Puts at $2.95 or less
-- Set stop-loss at the 200-day MA
-- Set price target at $5 for a potential 70% gain in 2-3 months

If you have a question or comment about today's strategy, please send it to editors@profitabletrading.com.

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