For Investors in the Auto Sector, There’s More than Tesla or GM
Investors can become limited in their thinking at times. Perhaps the limitations come from the headlines. For example, if an investor follows the news, they may start to think about the auto sector in terms of Tesla or old line auto manufacturers from Detroit like GM or Ford.
But, there are many other companies involved in that sector. One that might be overlooked is Lithia Motors, Inc. (NYSE: LAD).
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LAD is an operator of automotive franchises and a retailer of new and used vehicles and related services. Recently, the company noted that it offered 30 brands of new vehicles and all brands of used vehicles in 154 stores in the United States and online at Lithia.com, DCHauto.com and CarboneCars.com.
Its Domestic segment consists of retail automotive franchises that sell new vehicles manufactured by Chrysler, General Motors and Ford. Its Import segment consists of retail automotive franchises that sell new vehicles manufactured primarily by Honda, Toyota, Subaru, Nissan and Volkswagen.
Its Luxury segment consists of retail automotive franchises that sell new vehicles manufactured primarily by BMW, Mercedes-Benz and Lexus. The franchises in each segment also sell used vehicles, parts and automotive services, and automotive finance and insurance products.
Could Earnings Reverse a Down Trend?
Recently, LAD reported earnings and the stock jumped.
ZACKS reported, Lithia Motors (LAD) came out with quarterly earnings of $2.83 per share, beating the Zacks Consensus Estimate of $2.58 per share. This compares to earnings of $2.18 per share a year ago. These figures are adjusted for non-recurring items.
This quarterly report represents an earnings surprise of 9.69%. A quarter ago, it was expected that this auto dealership chain would post earnings of $2.98 per share when it actually produced earnings of $2.52, delivering a surprise of -15.44%.
Over the last four quarters, the company has surpassed consensus EPS estimates two times.
Lithia Motors, which belongs to the Zacks Automotive – Retail and Whole Sales industry, posted revenues of $3.09 billion for the quarter ended September 2018, missing the Zacks Consensus Estimate by 4.63%. This compares to year-ago revenues of $2.69 billion.
The company has topped consensus revenue estimates three times over the last four quarters.
Lithia Motors has been in a down trend and lost more than 30% since the beginning of the year.
The rally pushed the stock above its steep down slope and could be the beginning of an important reversal.
A Trade for Short Term Bulls
As with the ownership of any stock, buying LAD 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 LAD
For LAD, the November 16 options allow a trader to gain exposure to the stock.
A November 16 $90 call option can be bought for about $2.10 and the November 16 $95 call could be sold for about $0.97. This trade would cost $1.13 to open, or $113 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 $113.
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 LAD the maximum gain is $3.87 ($95 – $90 = $5.00; $5.00 – $1.13 = $3.87). This represents $387 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $113 to open this trade.
That is a potential gain of about 342% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.