A Possible Triple Digit Gain With $159 in Risk
Trade summary: A bull call spread in Pinduoduo Inc. (Nasdaq: PDD) using the June 17 $50 call option which can be bought for about $5.92 and the June 17 $55 call could be sold for about $4.33. This trade would cost $1.59 to open, or $159 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $1.59. The maximum gain is $341 per contract. That is a potential gain of about 114% based on the amount risked in the trade.
Now, let’s look at the details.
This trade is in a Chinese company which explains the large potential gain. There is a higher than average risk of accounting fraud in Chinese companies. That does not mean the companies must be avoided. It means risk must be managed and spread trades are a powerful risk management tool.
GlobeNewswire noted, “Pinduoduo is a technology platform and one of the leading Chinese e-commerce players. Recently the company announced it will subscribe to a $200 million in convertible bonds issued by household appliance and electronics retailer GOME Retail Holdings Limited as part of a strategic partnership to bring more value for money merchandise to the company’s 585.2 million users.
The bonds will have a coupon rate of 5% per annum and a tenure of three years, with an option to extend by two years at the election of PDD.
“This strategic partnership is a win-win-win,” said Mr. David Liu, Vice President of Strategy at PDD. “Consumers win because they get a wider range of top domestic and international brands at competitive prices, GOME wins because they can broaden their access to our 585.2 million users, and PDD wins because we enhance our foothold in household appliances and electronics.”
The tie-up marks the first strategic investment by PDD and comes after its $1.1 billion share placement to long-term investors in March, when the company said it will use the proceeds to enhance user experience. The partnership also strengthens the e-commerce platform’s position in household appliances and electronics while accelerating its push into consumer-led manufacturing.
As part of the partnership, PDD will help bring the entire GOME product range, including top domestic and international brands such as Siemens, Sony, Haier, Gree and Midea, onto the PDD platform at competitive prices.”
The stock has traded near new highs recently, even as the broad market sold off.
The weekly shows that PDD broke out of a trading range last summer and is now positioned for another possible up leg.
However, risk must be considered when trading companies based in China.
A Specific Trade for PDD
For PDD, the June 17 options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A June 17 $50 call option can be bought for about $5.92 and the June 17 $55 call could be sold for about $4.33. This trade would cost $1.59 to open, or $159 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $1.59.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in PDD the maximum gain is $3.41 ($55- $50= $5; 5- $1.59 = $3.41). This represents $341 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $159 to open this trade.
That is a potential gain of about 114 % based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying PDD could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but PDD the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.