Chipotle Could Be Back on Track
Chipotle Mexican Grill, Inc. (NYSE: CMG) is known for many things. The company focuses on delivering high quality food, as they explain:
“When Chipotle opened its first restaurant in 1993, the idea was simple: show that food served fast didn’t have to be a “fast-food” experience. Using high-quality raw ingredients, classic cooking techniques, and distinctive interior design, we brought features from the realm of fine dining to the world of quick-service restaurants.
Over 23 years later, our devotion to seeking out the very best ingredients we can–raised with respect for animals, farmers, and the environment–remains at the core of our commitment to Food With Integrity. And as we’ve grown, our mission has expanded to ensuring that better food is accessible to everyone.”
One way to track the company’s success is to look at how business has grown. Recently, they opened their 2,500th restaurant, a fact that demonstrates significant growth.
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Earnings Also Demonstrate Growth
According to Jim Cramer at TheStreet, “CMG reported fantastic numbers on Wednesday night, with a colossal 6.1% comparable-sales figure coupled with healthy margins.” The stock price jumped on the news.
Cramer also noted another factor the company is known for, food borne illnesses:
“It’s been a long road back from the food borne illness woes that plagued the chain — first beginning in the summer and winter of 2015 and then, again in the summer of 2017. Those incidents crushed the comps and, of course, the stock, which traded as low at $250 back in February of last year.”
Those problems could be behind the company now. That would set CMG up for potential gains in the long run. But the stock appears to be richly valued with a price to earnings (P/E) ratio above 70. Long term bulls could be buyers but short term strategies could decrease the risks in the stock.
In particular, short term strategies based on options could offset risk while allowing investors to participate in some of the potential follow through to the up side that is possible after the strong earnings report.
A Trade for Short Term Bulls
As with the ownership of any stock, buying CMG 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.
A Specific Trade for CMG
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
For CMG, the February options allow a trader to gain exposure to the stock.
A February 15 $600 call option can be bought for about $10 and the February 15 $610 call could be sold for about $5.45. This trade would cost $4.55 to open, or $455 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 $455.
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 CMG the maximum gain is $5.45 ($610 – $600 = $10; $10 – $4.55 = $5.45). This represents $545 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $455 to open this trade.
That is a potential gain of about 19.7% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.