Airlines Aren’t In the Clear Yet, So You Can Make 61% Off This Airline
Trade summary: A bear call spread in United Airlines Holdings, Inc. (Nasdaq: UAL) using July $33 call options for about $5.90 and buy a July $37 call for about $4.37. This trade generates a credit of $1.53, 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 $247. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($153). This trade offers a potential return of about 61% of the amount risked.
Now, let’s look at the details.
Barron’s reported that “Airline stocks continued a rapid descent Wednesday as analysts cautioned that the recent rally in the stocks may not be sustainable.
Despite signs of a turnaround in passenger traffic, the stocks have gotten ahead of themselves, according to JP Morgan analyst Jamie Baker, who lowered estimates for second-half revenue across the board and downgraded shares of UAL and JetBlue Airways from Neutral to Underweight ratings.
“We do not believe the current pace of equity ascent can be potentially maintained for much longer,” Baker wrote in a note published [recently]. United and JetBlue have “overshot” their price targets, he said, though he did sound more positive on Alaska Air Group (ALK), raising his price target to $54, up from recent prices around $46.
The stocks have had a significant bounce since their lows in mid-March, climbing on signs that domestic air travel is recovering. Airlines have announced more robust summer flight schedules, and they are gradually reducing their daily operating losses as traffic comes back and load factors (the percentage of a flight’s ticketed passengers) start to improve.
Nonetheless, an industry trade group issued a grim outlook for the industry [recently], expecting airlines globally to post losses of $84 billion this year and nearly $16 billion in 2021.
Baker sees headwinds building, for a variety of reasons. One is that the summer travel bump probably won’t be sustained this fall, when business travel would need to pick up the slack—there are few signs that large companies are approving business travel.
“The autumn of discontent is gradually approaching, which is why we don’t view increased summer schedules as a harbinger of solid recovery,” Baker writes.
The longer term chart shows that UAL, like other airlines, had stalled since last summer. In the sell off, UAL was among the biggest losers. Warren Buffett admitted that he sold in that decline.
Recent gains have been driven by speculation with analysts believing that airlines and other low priced stocks are being day traded by individuals. This does not change the fundamentals or create conditions for a long term rally.
Shorting shares of the stock to benefit from weakness 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 UAL
For UAL, we could sell a July $33 call for about $5.90 and buy a July $37 call for about $4.37. This trade generates a credit of $1.53, 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 $153. The credit received when the trade is opened, $153 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $247. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($153).
This trade offers a potential return of about 61% 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 $33 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 $247 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.