After Rallying 200%, This Stock Could Provide an 148% Gain
Trade summary: A bull call spread in Restoration Hardware Holdings, Inc. (NYSE: RH) using the June $230 call option which can be bought for about $23.02 and the June $240 call could be sold for about $19. This trade would cost $4.02 to open, or $402 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 $4.02. The maximum gain is $5.98 per contract. That is a potential gain of about 148% based on the amount risked in the trade.
Now, let’s look at the details.
The news was unusual. It’s a famous short seller publishing a bullish piece of research. The stock is already up sharply, and this news could drive further gains.
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RH was the subject of the research as Benzinga reported,
Activist investor and famed short seller Andrew Left of Citron Research said [recently] that RH is the “clear winner” of a potential large scale shift in American workers outside of expensive, densely populated urban centers.
Left published a bullish note on his latest long position … and set a $400 price target for the stock.
The price target implies roughly 100% upside from current levels, but Left said he wouldn’t be surprised if the stock made it to $800 in time as Wall Street begins to fully appreciate the power of its business model.
Left said many of the top market performers of the past couple of months have been short-term work-from-home trades like Wayfair Inc (NYSE: W), but Restoration Hardware is a long-term play on what he sees as a secular shift in the US economy.
“Regardless of the possibility of a vaccine, the trend of moving out of cities to the suburbs for larger living spaces where people can work from home and the home is a sanctuary will be long-lasting,” Left said.
Left said Restoration Hardware’s target customer demographic is the “upwardly mobile and style conscious consumer” that will soon be looking to move to the suburbs in the modern remote work environment.
Left pointed out that the average order size on Wayfair is $235, whereas the most popular Restoration Hardware item is a $10,000 cloud couch.
The company is optimistic it can grow its revenue from between $2 billion and $3 billion today to $20 billion in the long term. Left said even if the company only makes it halfway to that goal, $10 billion in revenue implies at least a $1,000 stock price.
In the near term, Left says the company should generate the strength of its business by posting positive revenue growth in the second quarter, the quarter many analysts say will mark the bottom of the current downturn.
Left said the valuation gap between Restoration Hardware and both Wayfair and other luxury brands has never been wider.
“We have always been a fan of the product and the stock and now the new way of living will propel this business model into hyper speed,” Left wrote.”
The longer-term chart puts recent market action in perspective. The stock recovered from the market crash rather swiftly. This indicates traders are excited about the stock’s potential, even before short sellers went long.
A Specific Trade for RH
For RH, the June 19 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 19 $230 call option can be bought for about $23.02 and the June 19 $240 call could be sold for about $19. This trade would cost $4.02 to open, or $402 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 $402.
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 RH, the maximum gain is $5.98 ($240- $230= $10; 10- $4.02 = $5.98). This represents $598 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $402 to open this trade.
That is a potential gain of about 148% 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 RH 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 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.