EBAY Could Provide a Short-Term Gain of More than 300%
Trade summary: A bull call spread in eBay Inc. (Nasdaq: EBAY) using the August $55 call option which can be bought for about $1.48 and the August $60 call could be sold for about $0.52. This trade would cost $0.96 to open, or $96 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 $96. The maximum gain is $404 per contract. That is a potential gain of about 320% based on the amount risked in the trade.
Now, let’s look at the details.
EBAY rallied after analysts raised their share-price targets for the online retailer, which has thrived amid the coronavirus pandemic.
Deutsche Bank analyst Kunal Madhukar lifted his rating on the stock to buy from hold and his price target to $57 a share from $42, according to The Street.
That provides prospects of additional gains even after the stock’s recent rally.
The report continued, “While the stock’s strong recent rally – 80% in the past three months – “could fade when the ongoing demand surge alleviates, … eBay is not getting credit for the sales it likely would be able to retain on the platform,” he wrote in a commentary cited by Barron’s.
Buyers are reporting positive experiences with eBay, Madhukar said. He also says the analyst consensus earnings forecast isn’t high enough, since it fails to encompass much if any growth in the second half of the year.
EBay should get more credit in the market for its payments business, which will help boost earnings, Madhukar said according to Barron’s.
He says eBay’s valuation is attractive compared with the S&P 500 and other e-commerce stocks.
The online auction house and retailer has a forward price-earnings multiple of just under 16, according to Morningstar. That compares to almost 25 for the S&P 500 as of June 19, according to Birinyi Associates.
Meanwhile, SunTrust Robinson Humphrey increased its share-price target to $54 from $50, leaving its rating at hold.
EBay is enjoying “a Covid-induced boost to e-commerce, which is bringing in new customers/reactivating old ones,” the firm wrote in a report cited by Bloomberg.
But eBay “may not be able to hold on to these customers” after the pandemic, which means its strong growth in gross merchandise volume “may not be sustainable in a more normalized environment.”
The longer-term chart shows that stock is extended after a strong rally. This means risks are high and risk management should be a primary concern for traders when a stock’s move is, in essence, parabolic.
A Specific Trade for EBAY
For EBAY, the August 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 August $55 call option can be bought for about $1.48 and the August $60 call could be sold for about $0.52. This trade would cost $0.96 to open, or $96 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 $96.
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 EBAY, the maximum gain is $404 ($60- $55= $5; 5- $0.96 = $4.04). This represents $404 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $96 to open this trade.
That is a potential gain of about 320% 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 EBAY 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.