Layoffs Could Still Mean Income for Investors
Trade summary: A bear call spread in American Airlines Group Inc. (Nasdaq: AAL) using September $12 call options for about $1.66 and buy a September $15 call for about $0.47. This trade generates a credit of $1.19, 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 $181. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($119). This trade offers a potential return of about 65% of the amount risked.
Now, let’s look at the details.
The Street reported that AAL plans to furlough up to 17,500 employees as demand for travel remains weak.
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The stock moved down on the news.
The reported noted, “That reduction comes in addition to 1,500 administrative and support workers laid off in August but continuing to get paid through Oct. 1. That’s when the government’s payroll protection aid to the airline industry ends.
The close of the six month payroll protection program is responsible for the move, American Chief Executive Doug Parker and President Robert Isom wrote in a letter to employees, cited by The Dallas Morning News.
“The coming weeks and months will be some of the most difficult we have ever faced,” they said.
“Today is the hardest message we have had to share so far – the announcement of involuntary staffing reductions effective Oct. 1. So, as Sept. 30 approaches, we have announced reductions in service, including the complete elimination of service to certain markets in early October, and today we are announcing the related reductions in our workforce.”
American said last week that it was eliminating service to 15 small cities in October, when a federal requirement to serve those airports ends. The affected cities include Sioux City, Iowa; New Haven, Conn.; and Springfield, Ill.
The furloughs unveiled [recently] include 8,100 flight attendants and 1,600 pilots, The Dallas Morning News reported. The furloughs will come from American and its regional carriers Envoy, PSA and Piedmont.
Another 23,000 American workers have accepted voluntary leaves and buyouts.”
The stock has been in a strong down trend for years. This news could break the support level that formed in the past few months.
To benefit from a decline, traders could short the stock. Selling short involves borrowing shares from a broker, selling them and buying back later. If prices fall, traders who are short can earn a profit when they buy at a price below their sell price. If prices rise, short trades result in a loss.
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 AAL
For AAL, we could sell a September $12 call for about $1.66 and buy a September $15 call for about $0.47. This trade generates a credit of $1.19, 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 $119. The credit received when the trade is opened, $119 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $181. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($119).
This trade offers a potential return of about 65% 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 AAL is below $12 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 $181 for this trade in AAL.
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.