An Upgrade Sends This Retailer Higher
Trade summary: A bull call spread in Shopify Inc. (NYSE: SHOP) using the July $900 call option which can be bought for about $58.18 and the July $905 call could be sold for about $54.71. This trade would cost $3.47 to open, or $347 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 $3.47. The maximum gain is $153 per contract. That is a potential gain of about 44% based on the amount risked in the trade.
Now, let’s look at the details.
Shopify stock hit record heights Thursday after RBC Capital analyst Mark Mahaney lifted his target on the e-commerce software company’s shares to a Street-high $1,000 from $825, according to Barron’s.
Now, the company “tops the $100 billion market cap level for the first time, and eclipses Royal Bank of Canada —Mahaney’s employer, as it happens—as the most valuable publicly traded company based in Canada.
Shopify shares have more than doubled year to date, with the most recent boost coming from a new distribution deal with Walmart (WMT). The company has been a clear beneficiary of the shift to online commerce, last month reporting better-than-expected first-quarter financial results.
The stock now carries a breathtaking valuation—47 times current estimated revenues, and 1,700 times the consensus Street earnings estimate for this year of 50 cents a share. But Mahaney is bullish nonetheless.
Mahaney, who repeated his Outperform rating on the stock, contends the market underappreciated three things about Shopify: the potential total addressable market; the potential to boost its “take rate,” or the piece it gets from transactions; and operating margin expansion. He also notes that U.S. online retail sales were up 31% in May, accelerating for the fourth consecutive month.
“In our view, consumer buying patterns have changed permanently,” he writes. Mahaney contends Shopify is addressing a $16 trillion global retail market (excluding China). His calculation: Apply a take rate of 5%, and you get an addressable market of $800 billion—and Shopify’s market share is less than 1% of that.
Mahaney contends that the company can boost the take rate by 30 to 40 basis points through increased adoption of its payments program, and another 100 to 110 basis points with additional value-added services like shipping and fulfillment. Shopify’s effective total take rate was 2.6% in 2019, below the estimated total take rate for Amazon’s Multi-Channel Fulfillment network of 5% to 15%. He thinks that provides a “reasonable long-term bogey” for Shopify.
Taking the long view, Mahaney says the company can reach $25 billion in revenue by 2028, “making it one of the largest platform companies.” And at that point, it should be able to reach 20% operating margins with 40% gross margins, he adds.
However, there are risks. The chart shows the stock is extended.
A Specific Trade for SHOP
For SHOP, the July options allow a trader to gain exposure to the stock. This trade will be open for about four weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A July $900 call option can be bought for about $58.18 and the July $905 call could be sold for about $54.71. This trade would cost $3.47 to open, or $347 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 $347.
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 SHOP, the maximum gain is $1.53 ($905- $900= $5; 5- $3.47 = $1.53). This represents $153 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $347 to open this trade.
That is a potential gain of about 44% 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 SHOP 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.