News Analysis date published New: 
Wednesday, October 3, 2012 - 16:00
New Date created: 
Wednesday, October 3, 2012 - 17:22
New Date last updated: 
Wednesday, October 3, 2012 - 16:00

This Retail Stock's Nosedive Could Deliver Traders 43%-Plus Gains

Wednesday, October 3, 2012 - 4:00pm

Market leaders often make for great shorting candidates. They tend to gain more than the overall market averages on the upside, and then usually fall more than the average stock on the downside. These are the stocks bought by momentum traders who are looking for the fastest-moving stocks to hold as long as they are going up. These traders often follow rules to set stop-losses 8%-10% below their purchase price, and their selling can push the price lower, creating a good short trade opportunity.

One of the best-performing stocks during the past year has been Ross Stores (Nasdaq: ROST), a retailer known for deep-discount prices on brand-named goods that it sells at more than 1,100 Ross Dress for Less and dd's Discounts stores.

The stock price moved up more than 100% in a year's time before peaking at $70.82 a share in August. Since then, this one-time market leader has seen its relative strength (RS) collapse as the price fell while the market moved higher. The price has now broken its uptrend line and formed a minor topping pattern on the weekly chart.

The collapse in RS near the top is often a sign that a deep decline is coming for a stock. This kind of stock will usually no longer be a favorite of momentum traders after RS falls below 70, and that reduces demand for the stock. Without demand for the stock, the price should fall.

The topping pattern points to a near-term target of about $60.18 a share, a price that should be reached before the end of December. Longer term, a price target of $52.65 a share would reward traders who short the stock with a gain of about 20%. This target is based on technicals and fundamentals.

From a fundamental perspective, earnings growth is expected to slow sharply, and that could be one of the factors behind the stock's recent price action. As traders realized the earnings would slow, the stock has formed a rounding top. Earnings had been growing at an average rate of about 35% a year during the past five years, but analysts now estimate Ross Stores will see growth averaging only 13.5% a year in the future.

Some analysts believe that a stock trades at fair value when the price-to-earnings (P/E) ratio is equal to the earnings growth rate. Using this guideline, we would expect to see Ross Stores fall to a price of about $52.65, which would be 13.5 times next year's estimated earnings of $3.90 a share.

This price target also represents a 50% retracement of the large price rise that peaked in August. Stock prices rarely go straight up or down. After a large move, traders usually look for the stock to move in the opposite direction as some traders take profits. This down move after a price rise, or rise after a decline, is said to "retrace" a part of the previous price moves. A typical retracement in a volatile stock like Ross Stores would cover about 50% of the earlier move, yielding a price target in this case near $52.65.

To take advantage of this trading opportunity, investors should consider January 2013 put options. The $65 strike put is selling near $3.15, which represents a potential loss of only about 5% of the stock's price.

Investors shorting the stock would have to cover the small dividend yield of about 0.9%, which adds to the trading costs and decreases the potential returns. Options present a less expensive, and less risky, way to trade this stock on the short side.

Action to Take -- > Buy ROST Jan 2013 65 Puts at $3.50 or less,set stop-loss at $2 and set initial price target at $5 for a potential 43%-plus gain in less than four months. Investors can continue buying puts until the lower price target of $52.65 is reached.

Michael J. 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.

The StreetAuthority Insider is a subscriber-only, complimentary publication, exclusively for our paid customers. As a paid subscriber in good standing, you'll now be getting more exclusive access to more investing gurus than ever before. I hope you'll find these periodic missives always informative, occasionally entertaining and consistently helpful to your bottom line.