Losses on an Up Day Point to a Trade Opportunity
On Monday, hope for tax reform sent stocks soaring on the open. An hour into the trading day, more than three quarters of the stocks traded so far were higher. But, one name stood out on the list of stocks that were trading lower.
Ryanair Holdings plc (Nasdaq: RYAAY) had been the subject of extensive media coverage over the weekend.
Unionization Raises Concerns About Higher Costs for a Low Cost Carrier
Shares of Ryanair had fallen every day in the previous week. The company’s shares were weighed down by the company’s surprise decision to recognize trade unions. This step does seem to have averted a strike by its Irish pilots but raised concerns of higher labor costs.
Ryanair’s CEO Michael O’Leary announced that last week the company reached out to fledgling pilot organizations in Ireland, the U.K., Germany, Italy, Spain and Portugal indicating that it was ready to acknowledge them as representative bodies.
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The recent sell off in the stock has wiped out all of the stock’s gains from the past year.
Source: Bloomberg (note that prices are in Euros and reflect trading in the company’s home market)
For investors in the US, the recent decline has not fully wiped out the year to date profits because of exchange rate effects.
The decline, not surprisingly, coincides with analysts’ concerns about the company’s ability to generate profits going forward.
Credit Suisse downgraded the stock to “neutral” from “outperform,” citing concern that staff expenses will rise “significantly” beyond the 100 million euros ($118 million) forecast by Ryanair for fiscal 2019. That could mean the carrier losing much of its cost advantage over EasyJet Plc, analysts including Neil Glynn said, cutting their price target to 16.18 euros from 19.32 euros.
Recognizing the unions marks an abrupt change in policy for the company. But, a recent scheduling problem brought long simmering problems into focus. Pilot inflexibility forced the company to cancel 20,000 flights.
Analysts note the recognition comes after a series of mistakes by the CEO in recent years. Bloomberg noted that, “First, he messed up by failing to anticipate a pilot shortfall and then compounded things by seeming to question how hard it is to fly a plane (he insists his comments were misinterpreted).”
Inserting personal questions like that into negotiations can complicate the process. But, O’leary added to the problems later.
Ryanair threatened to freeze pilot benefits and move aircraft to other airports if staff went on strike. As problems continued to arise, the company responded by agreeing to pay pilots a little more and tweak other benefits in the hope the problem would go away.
But, it seemed Ryanair has pushed its highly-productive workers too far.
A Possible Silver Lining
Not all analysts view the changes as so negative. Stephen Furlong at Davy Holdings in Dublin cut his price target to 17 euros from 20 euros while maintaining his “outperform” rating, saying Ryanair costs should remain “materially below” those of competitors, continuing to spur growth.
“Perhaps it was inevitable that Ryanair’s market leadership position would lead to unionization,” Furlong wrote. “We have no doubt that it will remain the market-leading airline in Europe in terms of returns, cash flow generation and growth potential.”
Damian Brewer at RBC Capital Markets in London said in a note that there may be negative repercussions for other carriers as more pilots begin to push pay claims, “creating tensions for the entire industry.”
But, Brewer noted, that there is now the potential for the company to expand into new markets. Ryanair may at the same time find it easier to penetrate airports such as Paris Charles de Gaulle and some in Scandinavia if it comes to be seen as “more socially acceptable.”
Some believe investor worries about unionization are probably overblown. Ryanair’s profit doesn’t just reflect its ability to squeeze labor costs. Analysts noted that even if its labor bill increased by 50%, which seems unlikely, it would still have reported a 17% pretax profit margin last year. Ryanair competitor Easyjet Plc reported a margin of about 8%.
One analyst noted that Ryanair could make low cost changes to satisfy the staff like providing free coffee and uniforms for all staff, scrapping fees to enroll and train as cabin crew or paying contract staff for the time in-between flights. These are standard practices at other airlines.
The Trend Is Unlikely to Be Up
As the stock charts above show, and the news about the unions and labor relations confirms, the trend in Ryanair is now likely to be down, at least in the short run.
That down trend, or at the least a consolidation of price, for RYAAY is likely to endure until there is a significant change in the company’s news. This indicates traders who want to trade the trend in RYAAY should consider trades that benefit from moves to the down side.
To benefit from weakness, an investor could buy put options. But, as the chart shows, RYAAY has been in a downtrend over the past few days and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in RYAAY
For RYAAY, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a January 19 $110 call for about $1.00 and buy a January 19 $115 call for about $0.20. This trade generates a credit of $0.80, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $80. The credit received when the trade is opened, $80 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $420. The risk is found by subtracting the difference in the strike prices ($500 or $5.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($80).
This trade offers a return of about 19% for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if RYAAY is below $110 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 $420 for this trade in RYAAY.
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