How To Play The Stock Market Correction by Chad Shoop, The Sovereign Investor

This past Friday, my family and I spent the evening in the local mall — shopping for gifts and clothes as we approach Easter. As my wife and daughter ventured off into clothing stores, my son dragged me into GameStop.

After being in the store for just minutes, my son already had two handfuls of games that he wanted to take home.

But, before heading to the register, I looked up the prices online. As it turns out, these exact same games were going for $10 and $15 less elsewhere; one of them we could even download right on the game console for half the price.

We walked out without spending a dime in GameStop … and I don’t think we’re the only ones.

I am not telling you this story just to bash the company. Rather I want to point out a fundamental weakness that GameStop is faced with — growing price competition.

I believe this weakness will lead to a lower stock price for GameStop in the coming months — the same time span that many investors are anticipating for stocks, in general, to head lower.

Investors are exhausted and nervous. It’s been more than two and a half years since the S&P 500 had a 10% correction. Add to that the Federal Reserve adjusting its interest-rate outlook and a fragile economic recovery, and you have the makings for investors ready to hit the sell button at the slightest hint of trouble.

An easy way to protect against downside risk is to purchase S&P 500 put options. The beauty of this strategy is that it will protect almost any portfolio.

But, if you are looking for a leveraged bet on a correction, you stand to generate significantly more profit by identifying fundamentally weak stocks that are already headed lower — such as GameStop.

If we have a correction, great! Odds are the shares of GameStop will tumble farther and faster than the broader market.

But, if we don’t have a correction, then that’s even better.

Your portfolio continues to plow ahead with gains, and the shares of GameStop are still poised for a 20% decline in the coming months. Let me explain…

Hitting Stiff Competition

GameStop is trying to do the impossible — go from a brick-and-mortar store to an online retailer.

Whether it becomes successful with this transition isn’t all that relevant. What’s important to understand is that this monumental shift will create substantial concerns about the company and the worries over its ability to complete this shift successfully will be enough to drag shares lower.

The truth is … I already have my doubts.

When I searched online for prices as I stood inside GameStop, I used Google — and GameStop didn’t even come up as an option.

From a consumer’s perspective, GameStop has practically zero online presence. This is a huge problem for a company that is reducing its brick-and-mortar operations without adequate online sales to support its valuations.

Once buyers do find them online, likely through GameStop’s website, its prices don’t compare to that of other outlets. Brand new games and consoles are going to be evenly priced throughout its competitors, but to pick up the marginal buyers, which is what they need in order to gain market share, they will have to become competitive with pricing used games, consoles and accessories — and that’s going to cost them.

In attempting to compete at a lower price level, GameStop will be forced to cut margins, reducing its profitability.

Not only will this transformational shift to keep growing cash flows be nearly impossible, but it is merely the beginning for the firm. As of last quarter, online sales equated to only about 10% of its total revenues.

This all leads to a fall in profits and rising negative investor sentiment — two drivers that will push shares lower regardless of the broad-market direction.

If we do see a broad-market sell-off in the coming months like many expect, then this fundamental weakness will only fuel the sell-off in GameStop shares.

Use One Put to Profit From Two Drivers

There are two ways to play a drop in the shares of GameStop.

One is to short the stock. But since the company pays out a dividend that you would have to account for, I don’t recommend doing so.

Instead, you can buy a put option. This contract is a bet that the shares of the underlying security will drop. As the shares fall below the strike price, the value of the put option rises. The biggest risk with buying a put is that options can expire worthless, so you could lose what you paid for the option.

One option that would encompass the company’s next earnings announcement as well as the Federal Reserve’s expected rate hike is the October expiration option. I would buy the $34 strike (GME151016P00034000) put for about $3.10.

Keep in mind that options trade in contracts, with one contract representing 100 shares of stock. So this $3.10 option would cost you $310 per contract.

My initial price target for the stock is $30, which is 21% below today’s price.

The sooner a move to $30 happens, the more your options will be worth. I would look to sell half of your option position once the underlying price falls below $30, then hold the other half to see how the stock weathers its next earnings date and a possible Fed rate hike.

If we get a correction in the broader market, look for shares to tumble significantly lower. Back in 2012, near the time the S&P 500 experienced its last 10% correction, the shares of GameStop traded for less than $16 — a 57% decline from today’s price.

Regards,

Chad Shoop

Editor, Pure Income

GameStop: How To Play The Stock Market Correction