Following Warren Buffett on Airlines Could Generate a 96% Gain
Trade summary: A bear call spread in Spirit Airlines, Inc. (NYSE: SAVE) using August $15 call options for about $2.38 and buy an August $17.50 call for about $1.15. This trade generates a credit of $1.23, 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 $127. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($123). This trade offers a potential return of about 96% of the amount risked.
Now, let’s look at the details.
Barron’s covered problems in the travel industry and highlighted some concerns related to SAVE.
“Leisure travel may be slowly coming back, but Spirit Airlines’ earnings report illustrates how bumpy the recovery has become.
Spirit reported an adjusted pretax loss of $364 million in the quarter, resulting in a loss of $3.59 a share. Revenue collapsed by 86% to $138.5 million. The results missed consensus estimate for an adjusted loss of $2.77 a share.”
The stock was down on the news.
More important for investors, Spirit indicated that demand trends remain choppy.
The ultralow-cost carrier, known for its cut-rate fares, estimated that its July, August and September capacity would be all over the map: down 18% in July, 35% in August and 45% in September, compared with last year’s periods. For the full third quarter, Spirit expects its capacity to be down 32%.
That would be a triumph over the second quarter, when capacity was down 83%.
But Spirit cautioned investors not to read too much into its forecasts. “The situation remains very fluid and actual capacity adjustments may be different than what the company currently expects,” the firm said.
Spirit’s revenue in the quarter would have been much worse, in fact, if the airline hadn’t made money off “breakage”—unredeemed flight credits, no-show revenue and cancellation fees—along with “brand” revenue from the sale of $9 Fare Club memberships (which cost $69.95 a year). Those sources of revenue accounted for nearly 44% of sales in the quarter, up from 8.5% a year earlier.
Spirit’s load factor—the percentage of seats with ticketed passengers—did show some big gains. The company said load factors rose from 18% in April to 79% in June, attributable partly to the airlines’ nimbleness in adjusting capacity quickly to meet demand. The overall load factor was just 49%, however, well below the 85% a year earlier—levels at which Spirit (and other airlines) can comfortably turn an operating profit.
Spirit said it would have broken even in June if not for a $50 million principal payment for future aircraft deliveries.
The airline also indicated that, while it made progress in reducing its operating losses, its cash burn rate may tick up. The daily cash burn declined from $9.5 million in April to $1.5 million in June, the airline said. But the company expects the rate to increase to between $3 million and $4 million in the third quarter.
Spirit appears to have enough liquidity to survive several more lean months. The airline said cash and available funding totaled $1.2 billion at the end of the second quarter. The company is receiving $335 million in payroll support under the Cares Act, and it has applied to the Treasury for a loan of $741 million, though it may not tap the full amount.”
The stock is in a long term down trend and appears to have encountered resistance after a brief bounce.
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 SAVE
For SAVE, we could sell an August $15 call for about $2.38 and buy an August $17.50 call for about $1.15. This trade generates a credit of $1.23, 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 $123. The credit received when the trade is opened, $123 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $127. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($123).
This trade offers a potential return of about 96% 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 SAVE is below $15 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 $127 for this trade in SAVE.
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.