Management’s Openness Could Help this Stock Deliver for Traders
Trade summary: A bull call spread in Trex Company, Inc. (NYSE: TREX) using the May 15 $85 call option which can be bought for about $6.71 and the May 15 $90 call could be sold for about $4.67. This trade would cost $2.04 to open, or $204 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $204. The maximum gain is $296 per contract. That is a potential gain of about 45% based on the amount risked in the trade.
Now, let’s look at the details.
The stock appears to be forming a bottom along with the broad stock market.
A potential catalyst for gains could be the company’s announcement that it has a plan to address the coronavirus.
Business Wire reported, “Trex Company, Inc. [recently] provided an update on the current impact of the COVID-19 pandemic on its business.
Jim Cline, President and Chief Executive Officer, and Bryan Fairbanks, Executive Vice President and Chief Financial Officer, issued a joint statement noting, “We are actively managing our business to respond to the conditions of this health crisis and will continue to evaluate the nature and extent of its impact.
“Our facilities continue to operate and we are following all CDC and public officials’ guidelines, along with implementing local emergency response plans at each location. Our dedicated employees have risen to the challenge to continue production in a safe and effective manner to meet consumer demand for Trex products.
“The COVID-19 pandemic represents uncharted territory, but we believe that Trex has key strengths that will enable us to weather this crisis.
From a financial perspective, we are in a strong cash position, with almost $150 million in cash at 2019 year-end, zero debt, and a new credit line that provides up to $250 million in liquidity. Additionally, Trex generates substantial free cash flow, and while we see no need to modify our current capital expansion program, it is modular and can be adjusted if necessary.
“As the industry’s low-cost producer, Trex has considerable financial and operational flexibility. At this time, we have no supply issues; however, we maintain inventories of materials sourced from diversified geographies, which allows Trex to better tolerate short term supply chain disruptions.
From an end-market perspective, we have approximately 100 exclusive distribution locations and 6,700 channel partner outlets where consumers can purchase our products.
“Our financial strength and business advantages give us confidence in our long term strategy to convert an increased share of the wood market to Trex composite products.
Our commitment to stakeholders is to take the appropriate actions to ensure the safety and well-being of our employees and partners, to leverage our strengths and ensure financial flexibility, while at the same time complying with any governmental orders relating to COVID-19.
We look forward to discussing our first quarter results and second quarter outlook in early May.”
The ability to withstand change could help the stock bounce off support which can be seen in the weekly chart below.
A Specific Trade for TREX
For TREX, the May 15 options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A May 15 $85 call option can be bought for about $6.71 and the May 15 $90 call could be sold for about $4.67. This trade would cost $2.04 to open, or $204 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 $204.
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 TREX the maximum gain is $2.96 ($90- $85= $5; 5 – $2.04 = $2.96). This represents $296 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $204 to open this trade.
That is a potential gain of about 45% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying TREX 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 TREX 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.