Good News From China Offers a Possible 66% Gain
Luckin Coffee Inc. (Nasdaq: LK), the chain that’s trying to overtake Starbucks Corp. in China, gave investors a jolt of optimism as it reported better-than-expected revenue and said it aims to break even next year.
The stock jumped on the news.
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“The Xiamen, China-based company, in its second set of quarterly results since going public in May, reported revenue of 1.54 billion yuan ($219.6 million) for the September quarter. That’s more than six times the year-earlier level, and tops the 1.47 billion yuan average of analysts’ estimates.
Luckin’s net loss widened to 531.9 million yuan from 484.9 million yuan a year earlier.
Luckin’s latest results provided some comfort to investors who have been looking for progress in the company’s financial position. The shares climbed 13% in New York to $21.46 each.
The stock had dropped almost 30% from a July peak as the Chinese startup faced questions over its strategy of burning millions of dollars to lure customers with discounts.
Other startups including Uber Technologies Inc. and WeWork Cos. have also come under scrutiny for spending heavily to chase blazing growth at the cost of profits.
Luckin’s restaurants are now profitable, and the company is on track to break even at the corporate level in the third quarter of next year, Chief Financial Officer Reinout Schakel said in an interview.
“We expect to take over Starbucks as the No. 1 coffee player in China by the end of this year in number of stores,” Schakel said. “We have a very strong brand.”
China is becoming an important market for coffee retailers as the traditionally tea-drinking nation develops a taste for java. While weaker consumer spending amid a trade war and slowing economy may present a challenge, the company could benefit from its lower prices.
The chain is very focused on its per-cup cost and affordability, Schakel said.
“We give a very clear message to our consumer around our value,” Schakel said. Luckin targets white-collar, middle-class office workers, who are a “resilient consumer,” he said.
Luckin claimed only 2.1% of the coffee market in China last year but wants to bolster that by opening more stores in two years than the industry giant has done in 20 years.
Starbucks, meanwhile, with more than a 50% market share in the Asian nation, is also planning to continue its rapid expansion by opening one store every 15 hours.”
The stock jumped to a new high.
A Trade for Short Term Bulls
As with the ownership of any stock, buying LK 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 LK
Every day, we scan the markets looking for trades with 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 LK, the December 20 options allow a trader to gain exposure to the stock.
A December 20 $30 call option can be bought for about $2.22 and the December 20 $32 call could be sold for about $1.02. This trade would cost $1.20 to open, or $120 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 $120.
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 LK the maximum gain is $0.80 ($32 – $30= $2; $2 – $1.20 = $0.80). This represents $80 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $120 to open this trade.
That is a potential gain of about 66% in LK, based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.