Earnings Trade: Is Gap Headed for a Hard Fall?

Following the bearish momentum of the past week, I’m taking up the case against retailer Gap (GPS), which is set to report earnings on May 21.

GPS dropped below its 20-day moving average Wednesday. The stock hasn’t closed a day below this trendline since March 11, which makes that plunge all the more noteworthy.

The problem with GPS is that there’s a huge “gap” down to the next level of support, which turns out to be the 50-day moving average at around $13.90.

That’s about 9% below current levels. It’s also in the neighborhood of a 50% retracement of the rally from the March low to last week’s high.

To simplify matters for those who eschew the technicals, the stock has plenty of room to fall.

Sentiment toward GPS is mixed. Actually, it may be tilted toward optimism when compared to the other retailers set to report earnings next week. Although only a third of the 12 covering analysts rate GPS shares a “buy,” none consider it a “sell.” Others retailers reporting next week — Lowe’s (LOW), Target (TGT) and Home Depot (HD) — are each carrying a heavy load of three “sells.”

Keep in mind that optimistic sentiment represents higher expectations and, thus, can create some vulnerability if those expectations aren’t met. Conversely, pessimism reflects lower expectations that often lead to upside earnings surprises.

Options players clearly believe in the company, as the put/call ratio is coming off an annual low. That tells us that heavy optimism is unwinding in the options pits. Note in the chart below what the stock has done after similar ratio bottoms.

GPS has little to no downside support on the charts and plenty of optimism to unwind. I’d consider buying puts on GPS ahead of its earnings announcement on May 21.

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Jon Lewis is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about Jon, read his bio here.