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A Sector Trade to Benefit From a Rally

A Sector Trade to Benefit From a Rally

One way to find trade ideas is to look at a heat map. A heat map is a chart that uses colors and shading to show how stocks are moving. In the chart below, dark green shading represents the biggest winners and dark red is used to show the biggest losers.

Source: StockMapper.com

In the chart, there is a cluster of companies in a single industry near the upper left corner, indicating they are among the day’s biggest winners. These are airline stocks, and a check of the NYSE ARCA Airline Index (^XAL) which is up more than 3%, confirms the industry is moving.

From there, we can turn to the news to identify a potential cause of the bullish price action.

The News From the United Kingdom is Bullish

The story that seems to be driving the airline industry higher on Monday is, a low-cost airline and packaged tour operator based in the United Kingdom, Monarch Airlines, fell into administration, the equivalent of filing for bankruptcy.

News reports noted that this is the largest U.K. airline to stop trading and the bankruptcy left 110,000 passengers stranded abroad. The administrators and the Civil Aviation Authority (CAA) will work together to bring those passengers home over the next two weeks.

It will be a significant undertaking. The CAA said that it is working with the British government to secure a fleet of 30 aircraft, flying to more than 30 airports, to bring back the passengers. “We are putting together, at very short notice and for a period of two weeks, what is effectively one of the UK’s largest airlines to manage this task,” CAA CEO Andrew Haines said Monday.

The action was attributed to mounting costs and the increasing competitiveness of the business environment for low cost air travel.

This is being seen as bullish news for large airlines. The bankruptcy of a low cost airline demonstrates that the industry is working on small margins. In an industry where profits are relatively small, it is difficult for small companies to survive.

As smaller companies exit the field, larger companies have the ability to increase revenue by raising prices. While this is not good for consumers, it is potentially good news for the airline industry.

This news seems to confirm the expectations of American Airlines CEO Doug Parker, who was recently quoted as saying that the airline industry may never “lose money again.”

Parker made the bold statement while speaking at American’s Media and Investor Day on Thursday, adding, “I don’t think we’re ever going to lose money again. We have an industry that is going to be profitable in good or bad times. We have an airline that is going to be profitable in good or bad times.”

Parker may be right because the industry has positioned itself to generate profits by avoiding price wars and reducing customer service.

Because this trend will impact the industry, all of the major airline stocks were trading higher. That means a trade in any of the stocks could be a winning trade.

A Specific Trading Strategy

To benefit from potential gains in airlines and a continuing rebound in the industry, an investor could buy shares of the iShares Transportation Average ETF (NYSE: IYT). This ETF includes significant stakes in several airlines.

Source: iShares

The ETF currently has about 19% of its assets invested in airlines. The remaining holdings include stakes in package delivery companies (like FedEx and UPS which benefit from increases in retail sales and industrial activity) and railroads (like Norfolk Southern and Union Pacific which benefit from increased economic growth).

While ETFs have many benefits, they are not always the best choice for traders. They are diversified investments which mean they can move slowly. They can also trade at relatively high prices, requiring a significant amount of capital to obtain enough exposure so an investor can earn a relatively large return.

While ETFs tend to move slowly to the upside, they actually can decline suddenly. To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the ETF while limiting risk to the amount paid for the options.

Although the risk is limited, it is still significant and is equal to 100% of the amount paid for the 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 call option. The call that is sold will have a higher strike price than the one that is bought.

Selling the call can help an investor pay for the costs associated with buying the first call. Potential risks and rewards of this strategy are both limited and illustrated in the diagram shown below.

Source: The Options Industry Council

This strategy is designed to profit from a gain in the underlying stock’s price but has the added benefit of avoiding the large up front capital outlay required to buy a significant position. Another benefit of the spread strategy is that it reduces the downside risks associated with outright stock ownership.

Any option strategy that works with a stock can also be applied in the same way to an ETF.

Both the potential profit and loss for the bull call spread are very limited and very well defined. The maximum loss of this trade is equal to the amount of the premium paid at the time the trade is opened.

The maximum profit of this trade is limited to the difference between the exercise prices of the options that are bought and sold, minus the amount of the debit that was paid to initially open the position.

For IYT, the October 20 options can be used. The October 20 $181 call option can be bought for about $1.00 and the October 20 $182 call could be sold for about $0.25.

The two transactions would result in a debit of about $0.75. Since each contract covers 100 shares, this trade would cost about $75 to open. This ignores the cost of commissions which should be quite small, just a few dollars, at a deep discount broker.

That is the maximum potential loss on the trade.

Remember that the potential gain is equal to the difference in the option exercise prices minus the premium paid to open the trade.

In this case, the maximum possible gain is $25.

To find the maximum gain, we find the difference between the two exercises. For this trade, that is $1 ($182 – $181). We then subtract the amount paid to open the trade from that amount. For this trade, that is $0.75 ($1 – $0.75). Since each contract covers 100 shares, the gain could be as much as $25.

The potential gain of $25 on the trade is equal to about 33% of the amount of capital risked, a favorable reward to risk ratio for many traders.

This trade will be open for just about two weeks. That is a short amount of time. If a trader could repeatedly make short term trades like this, they should be able to rapidly increase the amount of trading capital they have.

The bull put spread is just one example of how options are a versatile trading tool that can meet many of your trading objectives. This is true whether your overall objectives are related to income or growth.

In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors seeking exposure to sectors like real estate where tax reporting can be more complex.

These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.