An Analyst Upgrade Catalyzes a Possible 63% Gain
Trade summary: A bull call spread in Pinduoduo Inc. (Nasdaq: PDD) using the Jul $75 call option which can be bought for about $4.80 and the July $80 call could be sold for about $2.90. This trade would cost $1.90 to open, or $190 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 $1.90. The maximum gain is $310 per contract. That is a potential gain of about 63% based on the amount risked in the trade.
Now, let’s look at the details.
Analysts increased their opinion of PDD after the company announced earnings. Benzinga reported that “Bernstein initiated coverage on the company’s stock with an Outperform rating and announced an $89 price target.
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Pinduoduo provides a platform for buyers with value-for-money merchandise and fun and interactive shopping experiences. The company mobile platform offers a comprehensive selection of priced merchandise, featuring a social shopping experience that leverages social networks as an effective and efficient tool for buyer acquisition and engagement.
The company’s whole revenue is derived from within the People’s Republic of China.”
That’s a risk factor. Chinese stocks don’t always follow strict accounting standards. That means we should consider earnings as just one input. But earnings were good.
GlobeNewswire reported that total revenues in the most recent quarter were RMB6,541.1 million (US$923.8 million), an increase of 44% from RMB4,545.2 million in the same quarter of 2019.
Average monthly active users in the quarter were 487.4 million, an increase of 68% from 289.7 million in the same quarter of 2019.
Active buyers in the twelve-month period ended March 31, 2020 were 628.1 million, an increase of 42% from 443.3 million in the twelve-month period ended March 31, 2019.
Annual spending per active buyer5 in the twelve-month period ended March 31, 2020 was RMB1,842.4 (US$260.2), an increase of 47% from RMB1,257.3 in the twelve-month period ended March 31, 2019.
“Despite the unprecedented challenges in the first quarter, Pinduoduo has grown and now serves more than 600 million active buyers. We’re encouraged to see our next generation of leaders stepping up and shouldering the responsibilities of serving our users,” said Mr. Zheng Huang, Chairman and Chief Executive Officer of Pinduoduo.
“We remain committed to our users, merchants and ecosystem partners during this difficult period. In the first quarter, we adopted numerous measures to support them, including providing free traffic to farmers and small businesses, and stabilizing the prices of medical and other daily necessities that were in high demand.”
The results explain the stocks strong performance.
PDD has only been trading a short time, a factor that increases the risk the company’s financials are not in compliance with international standards.
While there are risks in PDD, there are opportunities. Spread trades can strike the balance between risk and reward on stocks like this.
A Specific Trade for PDD
For PDD, the July 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 July $75 call option can be bought for about $4.80 and the July $80 call could be sold for about $2.90. This trade would cost $1.90 to open, or $190 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 $190.
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 PDD, the maximum gain is $3.10 ($80- $75= $5; $5- $1.90 = $3.10). This represents $310 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $190 to open this trade.
That is a potential gain of about 63% 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 PDD 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.