Bad News That’s Not the Coronavirus Sets Up a Possible 81% Gain
Trade summary: A bear call spread in Shake Shack Inc. (NYSE: SHAK), using March 21 $62.50 call options for about $4.15 and buy a March 21 $67.50 call for about $1.90. This trade generates a credit of $2.25, 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 $275. 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 ($225). This trade offers a potential return of about 81% of the amount risked.
Now, let’s look at the details.
Bloomberg reported that a deal with GrubHub is affecting sales.
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“Shake Shack Inc. shares plunged … after the company posted worse-than-expected comparable sales and disappointing 2020 targets as growth in delivery slowed amid a shift to a sole partnership with Grubhub Inc.
“Results and guidance reinforced our concerns around Shake Shack’s transition to a single delivery partner and increased cannibalization, which drove our recent downgrade,” SunTrust analyst Jake Bartlett wrote. The headwind from the delivery transition is likely “to get worse, before it gets better.”
Other analysts remain cautious on the transition, as well.
The company also blamed cannibalization for the sales shortfall. Bartlett noted that the issue has been a concern for investors for a few years now, and he anticipates that it will remain a focus.
Here’s more of Wall Street analysts had to say following the report.
SunTrust, Jake Bartlett: With roughly 50% of the system recently solely integrated with Grubhub vs. 25% at the end of 2019, the analyst expects delivery sales to actually decline as Shack loses customers loyal to its prior partners.
“For instance, we found that at the end of January, DoorDash (private) stopped offering access to Shack Shack in Boston, Chicago and DC, all markets that have been recently integrated solely with Grubhub. Of course, we see the greatest risk to sales when SHAK solely integrates with Grubhub in NYC and loses DoorDash sales.”
Along with a shorter holiday season, adverse weather, less menu innovation and less of a lift from delivery, management said sales were also hurt by cannibalization from rapid development. This has “long been a topic” among Shake Shack investors — it contributed to negative comps in 2017.
“Cannibalization will likely remain a focus as delivery sales slow or decline, and SHAK increasingly focuses on infilling markets.”
Wedbush, Nick Setyan: The 2020 comp guidance is predicated on a second-half inflection after the Grub-transition, but the exact timing of the completion of the switch remains an unknown.
Setyan believes negative same-store sales guidance (down low single-digits) is “prudent” due to limited visibility around the ongoing transition to an exclusive Grubhub delivery partnership.
Restaurant-level margins were a positive surprise in the fourth-quarter, but could prove “optimistic” given the “absence of a stabilization” in second-half comparable sales growth and relatively tame food costs.
Morgan Stanley, John Glass: “With materially weaker traffic, fourth quarter missed our below-Street comp. expectations and guidance for 2020 suggests to us the start of the year could be similar or modestly worse.”
A more gradual transition to Grubhub as a sole delivery partner is the primary reason for the shortfall in the quarter, though weather compares, a shorter holiday season, and potentially cannibalization in in-fill markets were also contributors.
“In 2020, add to this the potential impact on licensing revenue from coronavirus.”
The stock is now in a confirmed downtrend with a lower high and a lower low likely.
SHAK faces structural problems and the stock is unlikely to recover until management shows the ability to manage deliveries, problems with cannibalization and other concerns. This could take several quarters and in the meantime, the stock is unlikely to rally.
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 SHAK
For SHAK, we could sell a March 21 $62.50 call for about $4.15 and buy a March 21 $67.50 call for about $1.90. This trade generates a credit of $2.25, 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 $225 The credit received when the trade is opened, $225 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $275. 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 ($225).
This trade offers a potential return of about 81% 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 SHAK is below $62.50 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 $275 for this trade in SHAK.
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.