Carvana Might Be an Ideal Post-Corona Retailer for Investors
Trade summary: A bull call spread in Carvana Co. (NYSE: CVNA) using the May 15 $80 call option which can be bought for about $9.25 and the May 15 $85 call could be sold for about $6.92. This trade would cost $2.33 to open, or $233 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 $233. The maximum gain is $267 per contract. That is a potential gain of about 114% based on the amount risked in the trade.
Now, let’s look at the details.
Carvana operates as an online-only used car dealer that allows customers to shop, finance, and sell or trade-in cars through their website. The company gives customers the option of having their purchased vehicles delivered to them or they can choose to pick them up at one of the company’s 24 car vending machines. Vehicles come with a seven day return policy.
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The Houston Chronicle called the company the “Amazon of Auto”. In 2019, it sold 177,549 vehicles and posted annual revenue of $3.94 billion, making it the third largest used-car retailer in the U.S.
Shares of CVNA jumped after analysts at Wells Fargo raised the stock’s price target to $75 from $50 a share.
According to The Street, analysts noted “that while high growth stocks like Carvana have been particularly vulnerable in the market downturn, the selloff in the stock has been overdone.
“We believe CVNA’s recently improved capital position (post $600M equity offering) and $2B increase/extension of CVNA’s loan purchase program with Ally considerably de-risk NT investor concerns,” said analyst Zachary Fadem.
The company has been proactive in its response to the economic downturn caused by the coronavirus pandemic, announcing earlier this week that it will give customers up to 90 days to make their first payment.
“Carvana has always been a company intensely focused on doing the right thing for our customers, and in a time when many are feeling the strain between needing safe transportation to an essential job and personal finances, we want customers to know we’re here for them,” said CEO Ernie Garcia.
“Our hope is that those who simply can’t put a vehicle purchase on hold are able to get what they need quickly and easily, so they can keep moving.”
The stock is on a stochastics buy signal in the weekly chart. Stochastics is a popular momentum indicator and the weekly signal indicates a longer term trend could be starting.
A Specific Trade for CVNA
For CVNA, the May 15 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 May 15 $80 call option can be bought for about $9.25 and the May 15 $85 call could be sold for about $6.92. This trade would cost $2.33 to open, or $233 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 $233.
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 CVNA the maximum gain is $2.67 ($85- $80= $5; 5 – $2.33 = $2.67). This represents $267 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $233 to open this trade.
That is a potential gain of about 114% 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 CVNA 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 CVNA 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.