Bounces Present Trading Opportunities For Investors
Trade summary: A bull call spread in XPO Logistics, Inc. (NYSE: XPO) using the April 17 $52.50 call option which can be bought for about $3.41 and the April 17 $55 call could be sold for about $1.75. This trade would cost $1.66 to open, or $166 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 $166. The maximum gain is $84 per contract. That is a potential gain of about 50% based on the amount risked in the trade.
Now, let’s look at the details.
COVID-19 has brought much of the economy to a halt. Many economists are now calling for a deep recession. Some are calling for a rapid rebound in the third quarter while others are offering some tempered forecasts that include contraction in that quarter as well.
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Some will drop even further from here.
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As with any economic trend, some stocks will do well while others will not. XPO is likely to be among the winners, even in a downturn.
GlobeNewswire reported that XPO, “a leading global provider of transportation and logistics solutions, has signed a long-term partnership agreement with Mercedes-Benz Parts Logistics to manage UK parts distribution through an integrated, digitally-managed transportation network.”
This is important because the UK will complete Brexit and this deal potentially demonstrates the company’s ability to navigate in those uncharted waters where customs rules are changing. It also helps XPO because the customer, Mercedes, is likely to maintain sales even in recession to well-heeled customers.
The news release noted, “XPO will distribute automotive parts to Mercedes-Benz’s UK retail and commercial vehicle dealerships, running over 40 routes daily from the Mercedes-Benz European Logistics Center in Milton Keynes and XPO’s overnight-delivery depots in Motherwell, Leigh, Wakefield, Gloucester and Taunton.
As part of this partnership, XPO has committed to investing in 42 new trucks that will be dedicated to serving the Mercedes-Benz passenger and commercial vehicle dealer networks.
Juan Manuel Santiago Mendez, CEO of Mercedes-Benz Parts Logistics – UK, said, “Our UK operation keeps consumers and businesses moving – it is responsible for more than 750,000 parts numbers.
We believe XPO has the scale, capabilities and expertise required to support our retailers and dealers with reliable distribution. They have designed a comprehensive solution to our high standards, and their technology should enhance network visibility.”
Dan Myers, managing director, transport – UK and Ireland, XPO Logistics, said, “Our team is looking forward to embarking on this new partnership with Mercedes-Benz, a premier brand synonymous with quality in the automotive industry.
The tailored technology solution we are providing will underpin service excellence and support Mercedes-Benz across its UK operations, lowering costs and increasing efficiency from day one.”
This news comes as the stock appeared to be finding a bottom.
The longer-term chart using weekly data shows the stock is at support that marked lows in 2018 and early 2017. This could bring bargain hunters into the market.
A Specific Trade for XPO
For XPO, the April 17 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.
An April 17 $52.50 call option can be bought for about $3.41 and the April 17 $55 call could be sold for about $1.75. This trade would cost $1.66 to open, or $166 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 $166.
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 XPO the maximum gain is $0.84 ($55- $52.50= $2.50; $2.50 – $1.66 = $0.84). This represents $84 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $166 to open this trade.
That is a potential gain of about 50% 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 XPO 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 has 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.