An Obvious Coronavirus Trade Could Deliver an 88% Gain
Trade summary: A bear call spread in Royal Caribbean Cruises Ltd. (NYSE: RCL), using March 21 $80 call options for about $8.40 and buy a March 21 $85 call for about $6.05. This trade generates a credit of $2.35, 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 $265. 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 ($235). This trade offers a potential return of about 88% of the amount risked.
Now, let’s look at the details.
RCL is a cruise ship operator. The company owns and operates three global cruise brands: Royal Caribbean International, Celebrity Cruises and Azamara Club Cruises. RCL also owns joint venture interest in the German brand TUI Cruises, the Spanish brand Pullmantur and the Chinese brand SkySea Cruises.
Together, its Global Brands and its Partner Brands operate a combined total of about 50 ships in the cruise vacation industry with an aggregate capacity of approximately 123,270 berths.
News for cruise ships has been generally bad for several weeks. For example, “The Centers for Disease Control and Prevention is reporting 59 confirmed cases of the coronavirus in the United States.
Of those 59, 42 are aboard the Diamond Princess cruise ship, while three of those people are from China.
The virus is also having a big impact on the $45 billion cruise line industry.
The latest blow came when a cruise ship out of Miami was denied access to ports in the Caribbean because a worker was ill.”
Shares of RCL reflect the news.
ZACKS reported that the company now expects an impact on earnings,
The company now expects earnings to be down by 90 cents due to the cancellation of cruises. Notably, it had previously projected 2020 earnings to be impacted by 65 cents. The company further added that if it has to cancel remaining cruise sailings in Asia through the end of April, it would hurt earnings by another 30 cents.
China remains of utmost importance to the Royal Caribbean brand. According to 2020 Cruise Industry News Annual Report, China constitutes 7.6% of the global cruise industry. Notably, the outbreak of the COVID-19 virus resulted in the cancellation of a number of voyages in other parts of Asia.
While cruise business from China and Asia fell significantly, bookings for the broader business outside Asia has also softened recently thanks to travel restrictions to contain the spread of the contagion.”
The weekly chart shows that the recent price move is bearish with the price breaking support and setting up a potential decline that could test support near $70.
Buying shares of the stock 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 RCL
For RCL, we could sell a March 21 $80 call for about $8.40 and buy a March 21 $85 call for about $6.05. This trade generates a credit of $2.35, 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 $35. The credit received when the trade is opened, $235 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $265. 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 ($235).
This trade offers a potential return of about 88% 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 RCL is below $80 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 $265 for this trade in RCL.
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.