Airline Challenges Place United in Position to Deliver a 58% Profit
Trade summary: A bear call spread in United Airlines Holdings, Inc. (Nasdaq: UAL), using April 17 $30 call options for about $2.27 and buy an April 17 $35 call for about $0.43. This trade generates a credit of $1.84, 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 $316. 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 ($184). This trade offers a potential return of about 58% of the amount risked.
Now, let’s look at the details.
Among the hardest sectors in the recent market rout is the airline industry with ZACKS noting that since the first week of February, an index tracking stocks in the industry declined by 47.4% while the broader market, tracked by S&P 500, is down a relatively small 21.2%.
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The Wall Street Journal reported that the stock market performance could be justified by the rapid decline in the industry’s performance,
“Major U.S. airlines are drafting plans for a potential voluntary shutdown of virtually all passenger flights across the U.S., according to industry and federal officials, as government agencies also consider ordering such a move and the nation’s air-traffic control system continues to be ravaged by the coronavirus contagion.
No final decisions have been made by the carriers or the White House, these officials said. As airlines struggle to keep aircraft flying with minimal passengers, various options are under consideration, these people said.
But amid the quickly spreading pandemic and mandatory stay-at-home orders covering some 80 million U.S. residents, airline executives, pilot-union leaders and federal transportation officials said they increasingly view as inevitable further sharp reductions from already-decimated schedules in passenger flights.
U.S. airlines have already eliminated the vast majority of international flying and have announced plans to cut back domestic flyin jl;u;g by as much as 40%.
Travelers are staying home at even greater rates. The Transportation Security Administration reported that passenger flow at its checkpoints was down more than 80% Sunday from the same day a year earlier.”
United Airlines noted, according to Zacks, that management “does not expect a rebound in travel demand for a while now.
In fact, the airline anticipates “demand to remain suppressed” into the next year “based on how doctors expect the virus to spread and how economists expect the global economy to react”.
The airline reduced its April capacity by more than 60% and plans to slash capacity further more in May and June. Even with a 60% reduction in capacity, the carrier expects load factor (percentage of seats filled by passengers) to fall to the teens or even to a single digit in April.”
This has pulled the stock down.
The long-term chart is bearish with the stock breaking support and entering a free fall.
After a decline like that, it should take time for buyers to appear to stabilize price. In the short term, neutral to bearish price action is most likely.
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 UAL
For UAL, we could sell an April 17 $30 call for about $2.27 and buy an April 17 $35 call for about $0.43. This trade generates a credit of $1.84, 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 $184. The credit received when the trade is opened, $184 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $316. 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 ($184).
This trade offers a potential return of about 58% 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 UAL is below $30 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 $316 for this trade in UAL.
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.