Earn 20% on This Beaten-Down Stock in Less Than Two Months

While irrational exuberance or excessive pessimism can lead traders to ignore fundamentals in the short term, stock prices are almost always related to earnings in the long term. Traders can benefit from fad stocks with short-term positions, but they can often find safer trades in the stocks of companies with real products and earnings that are temporarily beaten down.

That’s the case with today’s trade. This former market leader and household name announced that it was acquiring a competitor that is also a market leader and household name. Management said that the acquisition would increase profits beginning the first year, and this deal could put the stock on the path to recovery.

Tempur Pedic (NYSE: TPX) fell around 75% from April to June of this year after the company warned traders that sales and earnings would be slower than previously expected. Earnings were $3.18 in 2011, and are now expected to be about $2.79 in 2012.

That two month sell-off pushed the price-to-earnings (P/E) ratio down to 7.5, about half the market average. At those lows, Tempur Pedic was cheap, but cheap stocks can become cheaper and market prices can be irrational on the downside as well as the upside. Therefore, it is always best to wait for a stock to turn higher before buying.


Since making a 52-week low in June, Tempur Pedic is up about 48%. The company recently announced a plan to acquire competitor Sealy Corp. (NYSE: ZZ), and management said the deal would increase earnings to about $3.11 next year. With Tempur Pedic trading at about $30.55, this stock has a P/E ratio of less than 10 based on next year’s estimated earnings.#-ad_banner-#

Analysts expect growth to average about 13% over the next five years. Some investors use the price-to-earnings to growth (PEG) ratio to find the fair value of a stock. This ratio divides the P/E ratio by the earnings growth rate, and a value under 1 is considered to be undervalued. Tempur Pedic has a PEG ratio of 0.8. This offers a fundamental reason to expect the stock price of Tempur Pedic to rise.

While we could buy Tempur Pedic here, it would be nice to get it closer to those summertime lows. We might be able to do that and generate some income in the meantime by selling put options.

When you sell a put, you are agreeing to buy a stock at the option‘s exercise price at any time before the expiration date. An out-of-the-money put will only be exercised if the stock price falls. If the put is not exercised, the premium you receive as the seller is your profit on the trade.

Currently, November $27 puts on Tempur Pedic can be sold for about $1.15, so if we were required to buy Tempur Pedic in the event of a sell-off, we would get to buy a market leader with sound fundamentals at $25.85 ($27 strike minus $1.15 premium collected), which is about 8 times next year’s earnings. If the put is not exercised, we would earn about 20% on a margined position over the next seven weeks.

This is a win-win trade. If the price of Tempur Pedic drops, we buy a great stock at a great price. If the price rises, we enjoy a great return on a small investment in the form of income.

Action to Take –> Sell Tempur Pedic Nov 27 Puts for $1 or more. Do not use a stop-loss. If the puts expire worthless, you keep 100% of the premium as your profit, a 20% gain on a margined position in two months. If Tempur Pedic falls below $27, you own shares at $26 or less.

This article originally appeared on TradingAuthority.com:

Earn 20% on This Beaten-Down Stock in Less Than Two Months