A Safer Way for Investors to Trade Nikola
Trade summary: A bear call spread in Nikola Corporation (Nasdaq: NKLA) using October $25 call options for about $6 and buy an October $30 call for about $3.65. This trade generates a credit of $2.35, 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 $265. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($235). This trade offers a potential return of about 88% of the amount risked.
Now, let’s look at the details.
Nikola has been in the news quite a bit lately as Barron’s reported,
“Nikola founder and Executive Chairman Trevor Milton stepped down from the company. The stock is lower substantially because the change was catalyzed by a negative report from Hindenburg Research, which alleges, among other things, Milton hasn’t been truthful with investors. Nikola has refuted the charges.
Now Wall Street is weighing in. Some price targets are coming down, but no one has cut their stock rating.
Five analysts cover Nikola stock (ticker NKLA). Several have written notes covering Milton’s departure.
For starters, J.P. Morgan analyst Paul Coster maintained his Buy rating on Nikola stock, but took his target price to $41 a share from $45.
RBC analyst Joseph Spak made a deeper cut to his price target on Nikola stock than Coster, taking it to $21 from $49. “This was a hard, but necessary step for Nikola in wake of allegations against Milton raised by a short seller report and SEC investigation,” wrote Spak.
“Nikola’s stock will be in penalty box for a while as they look to rebuild credibility with Street.”
The Justice Department, working in concert with the Securities and Exchange Commission, is reportedly investigating Nikola for misleading investors. Nikola didn’t comment on the potential inquiry.
How long it takes to rebuild credibility, Spak didn’t state. Spak added that the short seller’s report raised a cloud over the company.
Wedbush analyst Dan Ives didn’t change his rating or price target. He rates shares Hold and has a $45 price target. He called the move shocking and said it “will be perceived by the Street as a major near-term gut punch.” He is on the sidelines until he has more confidence about hydrogen filling stations.”
The stock is now testing new lows. The chart below shows the trading history of NKLA which began trading officially in June.
The stock is under pressure and news could push the stock lower. Traders can benefit from declines with short trades.
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 NKLA
For NKLA, we could sell an October $25 call for about $6 and buy an October $30 call for about $3.65. This trade generates a credit of $2.35, 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 $235. The credit received when the trade is opened, $235 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $265. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($235).
This trade offers a potential return of about 88% 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 NKLA is below $25 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 $265 for this trade in NKLA.
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.