Kroger Could Deliver Quick Income of 41% To Investors
Trade summary: A bear call spread in The Kroger Co. (NYSE: KR) using July $30 call options for about $1.87 and buy a July $35 call for about $0.40. This trade generates a credit of $1.47, 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 $353. 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 ($147). This trade offers a potential return of about 41% of the amount risked.
Now, let’s look at the details.
KR reported earnings and as The Street reported, the stock fell on the news.
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In the report, the company beat “first quarter analyst estimates while also saying that 2020 comps guidance would be ahead of expectations.
Kroger reported net income of $1.21 billion, or $1.22 per share adjusted on revenue of $41.55 billion, up from $37.25 billion a year ago. Analysts were expecting the company to report earnings of $1.12 per share on sales of $40.71 billion for the quarter ended May 23.
“Under Restock Kroger, we have made significant investments over the last several years to establish a seamless digital ecosystem, strengthen Our Brands and our personalization capabilities, and to enhance product freshness and quality,” said CEO Rodney McMullen about the company’s digital presence.
While the company said that it would be difficult to offer guidance for this fiscal year due to the coronavirus pandemic, it did say that it expects to exceed its original 2020 outlook for same store sales growth and profit.
It did not, however, provide a new 2020 forecast. The company previously projected comps growth of more than 2.2% and earnings between $2.30 and $2.40 per share.
Digital sales for the first quarter jumped 92% compared to growth of just 22% in the previous quarter.
During the quarter, Kroger said it hired more than 100,000 “associates”, helped test nearly 83,000 patients for COVID-19 in 15 states and was one of only five U.S. retailers to “develop, staff and expand free COVID testing model in partnership with the federal and state governments.”
Despite these wins, Kroger dropped on the news. The decline comes with the stock near resistance and the chart indicates that a decline towards $28 could come quickly with no clear support before that level.
To benefit from a possible decline, traders can short shares a company. This involves selling shares that are not owned, borrowing the shares from a broker.
However, shorting shares of the stock exposes traders to significant risks in dollar terms. Technically, the risks could be unlimited.
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 KR
For KR, we could sell a July $30 call for about $1.87 and buy a July $35 call for about $0.40. This trade generates a credit of $1.47, 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 $147. The credit received when the trade is opened, $147 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $353. 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 ($147).
This trade offers a potential return of about 41% 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 KR 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 $240 for this trade in KR.
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.