Furloughs Show Bad Times and Possible High Income Await Traders
Trade summary: A bear call spread in United Airlines Holdings, Inc. (Nasdaq: UAL) using July $30 call options for about $2.98 and buy a July $35 call for about $0.83. This trade generates a credit of $2.15, 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 $285. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($215). This trade offers a potential return of about 75% of the amount risked.
Now, let’s look at the details.
Air travel is down this year. The chart below shows the details, as provided by the Transportation Security Agency.
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This is affecting airlines, as Yahoo Finance reports,
“UAL warned [recently] that it may be forced to furlough as many as 36,000 workers, or 45% of its workforce, as weak demand and travel restrictions in the wake of the coronavirus outbreak create “the worst crisis” the industry has ever faced.”
This news appears to be weighing on the stock.
The news continued, “According to United, 36,000 workers — or 45% of U.S. positions — may be impacted or laid off by October 1. Although 3700 have already taken an early-out option, the potential losses affect 15,000 flight attendants, 11,000 airport staffers, 5500 maintenance positions and 2250 pilots, the company told reporters on a conference call.
Fallout from the coronavirus pandemic is “the worst crisis to hit the airline industry and United Airlines,” a United executive said on Wednesday. “We can’t count on additional government support to survive.”
The executive said United is burning through $40 million per day despite a schedule that’s been cut to 20% of its usual capacity. In order to mitigate the impact of layoffs, United will begin talks with all 5 labor unions, and encourage a voluntary retirement program, among other options.
A provision of the CARES Act requires airliners to avoid furloughs or pay cuts. However, United suggested the bleak outlook leaves the airliner few other options.
“The truth is none of the decisions so far have been more difficult than the decision we are announcing today,” the executive added. “Involuntary furloughs that we worked so hard to avoid are the last option left.”
The longer term chart is bearish with recent price action forming a potential “dead cat bounce” pattern.
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 UAL
For UAL, we could sell a July $30 call for about $2.98 and buy a July $35 call for about $0.83. This trade generates a credit of $2.15, 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 $215. The credit received when the trade is opened, $215 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $285. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($215).
This trade offers a potential return of about 75% 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 UAL is below $30 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 $285 for this trade in UAL.
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.