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Traders Could Nail Down 67% Profits As This Stock Stumbles

 March 06, 2013 10:44 AM

Concerns are often raised in isolated news stories and research reports long before a problem becomes a crisis. Warnings that real estate was overvalued, for example, fell on deaf ears until the subprime mortgage crisis pushed the financial system to the brink of collapse in 2008. Now, concerns are being raised about student loans.

Wells Fargo Economics Group recently published a report showing the impact student loans are having on consumers and lenders. Most loans are made by the government, but private lenders are in this market as well, and all lenders are faced with the prospects of increased delinquencies.

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If the student loan problem gets much worse, then traders are likely to react as they did to the subprime crisis and sell all stocks related to the sector. This will include industry giants like SLM Corporation (Nasdaq: SLM) and smaller players like Discover Financial Services (NYSE: DFS).

Despite its relatively small exposure to student loans, we may see traders "throw the baby out with the bathwater" as they often do when troubled sectors make the news. Discover could also be facing other problems and the stock is an excellent short trade candidate. Using put options, traders could benefit from a sell-off in Discover without the risks a short seller would face.

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Discover has made only $8 billion worth of student loans, according to their latest reports. The company noted that it is applying strict underwriting standards in this market and delinquencies are low at 1%, compared with 2.7% at SLM. The high rate seen in the chart above is mostly related to delinquencies on government-originated loans. But the student loan business has a low profit margin and seems like a high-risk area for Discover to be involved in.

Student loans are expected to deliver a return on assets (ROA) of 2.5%, assuming the loss ratio remains unchanged. With delinquencies rising in this sector and possible political action to make the loans dischargeable in bankruptcy, an action that would increase lenders' losses, Discover seems to be making an optimistic assumption.

Discover is best known as a credit card company, where the ROA is a more attractive 4.5%. However, the company is also a small player in this sector. Recent data on the U.S. credit card market shows that Discover cards have only a 4.8% market share in 2012, down from 5% in 2010.

With a small market share in its primary market and a decision to pursue growth in lower margin businesses, like student loans, and personal loans where the ROA is 3%, Discover is facing a slowdown in earnings growth. Analysts expect the company to see average growth of 10.7% in earnings per share (EPS) during the next five years, about one-third the average growth of 31% seen in the past five years.

Despite the slow growth prospects, Discover is actually trading at a premium to its average valuation levels. The stock now has a price-to-earnings (P/E) ratio of 8.8 compared with an average ratio of 7.3 during the past five years. The current price-to-book (P/B) value of 2.2 is well above the five-year average of 1.3. The price-to-sales (P/S) ratio, price-to-free-cash-flow ratio and dividend yield are also well above average.

The chart shows that traders recognize Discover stock is overvalued. Shown below is the weekly chart with a number of indicators.

Discover is struggling with resistance offered by the 26-week moving average (MA). The price relationship to the MA is used to derive the price target of $32.23 shown in the chart. Price moves tend to be symmetrical, and a decline below an MA often mirrors the move above the MA. This concept was probably first discussed by Tom DeMark in The New Science of Technical Analysis.

Below the prices on the chart, relative strength (RS) is shown. RS is 3, indicating that 97% of stocks have outperformed Discover in the past six months. The Momentum of Comparative Strength (MoCS) converts RS to a Moving Average Convergence/Divergence (MACD) style histogram and support the sell argument. Stochastics is trending lower but is far from oversold, indicating that Discover still offers significant downside potential.

July $35 put options offer an attractive setup with limited risk. The $32.23 price target is so far below the current price that there is a large potential gain with a deep out-of-the-money put. Risk is limited to the price of the put, currently about $1.10. The put will be worth at least $2.50 if Discover falls to $32.50 before expiration in July.

From current levels, traders could double their money with this trade if the economy stumbles, consumer spending declines in the face of tax increases, student loan problems increase or interest rates rise. This trade is an excellent hedge for almost anyone concerned about the future.

Action to Take --> Buy Discover July 35 Puts at $1.50 or less. Do not use a stop-loss; risk is limited to the price paid for the options. Set initial price target at $2.50 for a potential 67% gain in five months.

This article originally appeared on ProfitableTrading.com:

Traders Could Nail Down 67% Profits as This Stock Stumbles

--Michael Carr

Michael Carr does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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