High Income From a Company Facing Regulatory Pressures
Trade summary: A bear call spread in Grubhub Inc. (NYSE: GRUB) using June $55 call options for about $4.20 and buy a June $60 call for about $2.04. This trade generates a credit of $2.16, 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 $284. 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 ($216). This trade offers a potential return of about 76% of the amount risked.
Now, let’s look at the details.
GRUB has been a company that reacts to the market. Founders saw a need for delivery, a service focused on delivery rather than a restaurant as the industry had existed for decades. But, New York City is challenging the company.
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“A package of bills aimed at helping small businesses struggling during the coronavirus outbreak was signed into law by Mayor de Blasio [recently} according to the NY Daily News.
One bill caps fees from delivery apps like Grubhub at 15% per order. Fees for additional services like marketing are limited to 5% per order.
The city will levy one $1,000 fine per overcharged restaurant per day.
Another bill signed Tuesday bars delivery apps from charging restaurants for phone orders that didn’t really take place. The laws will last for 90 days after the end of the state of emergency that de Blasio declared in March.”
New York is just one city looking at GRUB’s fees, “As restaurants struggle to stay afloat during the coronavirus pandemic, many have turned to delivery apps to serve customers until it is safe to return to dine-in service. But the fees these companies charge have left restaurant owners reeling.
City councils in New York, Los Angeles, San Francisco, Seattle and Washington, D.C., have recently voted to cap delivery companies’ fees at 15% of the price of each order. But Grubhub, which has recently been approached by Uber with a takeover offer, opposes the measures,” according to Forbes.
Despite fees that seem high, it’s important to remember than restaurant orders can be small and that leads to a struggle for profitability for restaurants and delivery services. As noted in Forbes
“It’s an industry that needs to change. Third-party food delivery has been unprofitable for years, despite fees as high as 30% that restaurants pay on each delivery order, plus additional fees for processing, delivery and marketing promotions that hurt already slim margins.
It was growing before the pandemic and surged once the lockdowns spread across the country.
Still, both Grubhub and Uber Eats are struggling to find profits doing it, and have been hurt by the sudden surge, which led all the services to defer or waive fees while offering discounts, loyalty rewards and special offers to consumers. “
GRUB has struggled to move higher after spurning that takeover offer. The stock is now trading in a narrow range and on slowing momentum.
The stock has lost more than a third of its value over the two years and could struggle at current levels where resistance is strong.
To benefit from weakness, it’s possible to sell a stock short but shorting 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 GRUB
For GRUB, we could sell a June $55 call for about $4.20 and buy a June $60 call for about $2.04. This trade generates a credit of $2.16, 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 $216. The credit received when the trade is opened, $216 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $284. 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 ($216).
This trade offers a potential return of about 76% 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 GRUB is below $55 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 $284 for this trade in GRUB.
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.