A Billion Dollar Loss Can Create Triple Digit income
Trade summary: A bear call spread in The Gap, Inc. (NYSE: GPS) using July $11 call options for about $2.65 and buy a July $15 call for about $0.57. This trade generates a credit of $2.08, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $192. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($208). This trade offers a potential return of about 108% of the amount risked.
Now, let’s look at the details.
Retailers have been among the hardest hit sectors in the economy. And as BBC News recently reported, the size of the losses companies in the sector face are larger than many analysts initially expected.
“Clothing retailer Gap has reported a loss close to $1 billion due to store closures because of the coronavirus pandemic.
The company was $932 million in the red for the three months to May, compared with a profit of $227 million in the same period last year.
It comes as Gap wrote off the value of the goods it holds by more than a quarter of a billion dollars.
With net sales falling 43% in the period, Gap’s chief executive Sonia Syngal said they continued to reflect “material declines in May as a result of closures” but added that online demand was improving.
Retailers of non-essential goods, especially clothing, have been hit hard by restrictions aimed to help slow the spread of Covid-19.
Shops have been shut across much of the world as retailers were forced to limit their businesses to online operations.
San Francisco-based Gap, which operates almost 2,800 stores in North America, said that more than half of its company-operated stores in the US have now reopened.”
The report continued, noting that the recovery might be complicated by legal issues, “Separately, Gap is is being sued by America’s largest shopping mall operator for refusing to pay rent for stores temporarily closed during the coronavirus pandemic.
Simon Property Group said in a lawsuit filed this week that the clothing retailer owes three months of rent, totalling $65.9m.
Gap has more than 390 stores at Indianapolis-based Simon’s malls, including its namesake brand, Old Navy and Banana Republic.
Simon Property Group temporarily closed all of its properties in March after major retailers at its malls, such as Gap, Macy’s and Nodstrom’s, shut their stores.
Large retailers, including Gap and sports shoe seller Foot Locker, have said they wouldn’t pay rent for stores that were forced to close due to the pandemic.
Gap did not directly mention the lawsuit during Thursday’s earnings conference call but chief financial officer Katrina O’Connell said “We’re just knee-deep in landlords today.”
“It’s very hard to say how long it will take, but I do know that one of our primary objectives is to use this opportunity to partner with our landlords to come up with a better profitability for the company.”
The stock has been a laggard in the recent recovery. Despite big gains, the sock failed to approach its pre-crash highs.
The longer-term chart shows that GPS has been in an extended downtrend and makes it appear likely that the recent rally is likely ending, giving way to a resumption of the stronger, long-term trend.
Shorting shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for GPS
For GPS, we could sell a July $11 call for about $2.65 and buy a July $15 call for about $0.57. This trade generates a credit of $2.08, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $208. The credit received when the trade is opened, $208 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $192. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($208).
This trade offers a potential return of about 108% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if GPS is below $11 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $192 for this trade in GPS.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.