A Retailer With a Possible Triple Digit Gain
Trade summary: A bull call spread in CVS Health Corporation (NYSE: CVS) using the June 17 $65 call option which can be bought for about $2.10 and the June 17 $70 call could be sold for about $0.63. This trade would cost $1.47 to open, or $147 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 $1.47. The maximum gain is $353 per contract. That is a potential gain of about 140% based on the amount risked in the trade.
Now, let’s look at the details.
CVS reported earnings according to The Street, the company “posted stronger-than-expected first quarter earnings Wednesday as coronavirus lockdowns boosted retail and pharmacy sales as customers stockpiled household items and medical prescriptions.”
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Traders seemed to like the news.
Details of the report were bullish.
“CVS said adjusted earnings from continuing operations for the three months ending in March were pegged at $1.91 per share, up 17.9% from the same period last year and 28 cents ahead of the Street consensus forecast.
Group revenues, CVS said, rose 8.3% to $66.8 billion, thanks in part to the addition of Aetna sales to the group’s top line and again topping analysts’ estimate of a $64.1 billion tally.
Front same store sales rose 8%, from last year CVS said, while comparable pharmacy store sales surged by 9.3%.
The group also confirmed its full-year profit forecast, projecting adjusted earnings in the region of $7.04 to $7.17 per share, and cash flow from operations in the range of $10.5 billion to $11 billion.
“When facing any health crisis, including this pandemic, we’re uniquely positioned to understand consumer and patient needs and how to address them. This includes increasing access to medicine and virtual care, and testing thousands for the virus every day to ready our country to reopen safely’, said CEO Larry Merlo. “We’re utilizing our innovation-driven health care model, scale and unique capabilities to benefit consumers across the health care system, and none of this could be done without the tireless dedication of our colleagues.”
Pharmacy Services revenues rose 4.2% to $34.98 billion, CVS said, “primarily due to growth in specialty pharmacy, brand inflation and increased total pharmacy claims volume, including greater use of 90-day prescriptions and early refills of maintenance medications as consumers prepared for the COVID-19 pandemic.”
Retail sales rose 7.7% to $22.75 billion while the group’s healthcare benefits division saw sales surge to $19.2 billion as it added Aetna’s operations to its legacy business.”
The fact that the company affirmed its guidance is potentially bullish. Many companies are pulling guidance due to a lack of visibility into sales potential.
The weekly chart shows CVS bouncing off support in a move that could carry it to recent highs where the stock would trade for about 10 times expected earnings.
A Specific Trade for CVS
For the CVS 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 $65 call option can be bought for about $2.10 and the June 17 $70 call could be sold for about $0.63. This trade would cost $1.47 to open, or $147 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 $147.
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 CVS the maximum gain is $3.53 ($70- $65= $5; 5- $1.47 = $3.53). This represents $353 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $147 to open this trade.
That is a potential gain of about 140% 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 CVS 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 CVS 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.