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Our Next Trade in Chipotle

Our Next Trade in Chipotle

You’ve heard this story before. Over a couple of days, a group of people reported getting sick after eating at a Chipotle Mexican Grill (NYSE: CMG). The company responded quickly, benefiting from knowledge gained in earlier experiences.

Chipotle immediately closed the restaurant which is located on the outskirts of Washington, in Sterling, Virginia. Management tried to get ahead of the news instead of letting rumors build. Jim Marsden, Chipotle’s executive director of food safety, said a “small number” of illnesses were reported and he noted the company is working with health authorities to determine the cause of the outbreak.

“The reported symptoms are consistent with norovirus,” Marsden said in a statement emailed to Bloomberg. “Norovirus does not come from our food supply, and it is safe to eat at Chipotle.”

Norovirus is actually fairly common. There are an estimated 20 million cases a year in the country. The disease can spread if someone comes in contact with a contaminated surface or infected person, or if someone ingests food that was touched by an infected person.

It’s likely the outbreak originated at Chipotle’s store but it is a slim possibility it is just a coincidence. The company has no choice but to deal with the news aggressively because it forces customers to reconsider the safety of dining at Chipotle.

Consumers still remember a series of outbreaks in 2015 that left customers sick and investors reeling. That crisis included an E. coli scare and a norovirus outbreak that left more than 140 students at a location near Boston College sick in December of that year.

Finally, the company seemed to be recovering and customers were returning to the restaurants.

Food Safety Might Not Be the Biggest Problem

Chipotle has been working to address a few problems with its business. Stores have been struggling with what executives often call “throughput” which means — moving customers in and out of line quickly.  They worry that slow moving lines are hurting sales as customers just go somewhere else.

In part, the problem with slow moving lines could be related to high employee turnover. The company is also working to hold down food costs which are higher than average.  These problems all present long term challenges to the company.

Management will now have to address all of these problems while assuring customers food is safe. The company responded aggressively to earlier problems and the food is most likely safe. But, convincing customers of that could be a challenge.

These operational concerns will highlight another problem management is dealing with. The stock price of CMG has been in a down trend for nearly two years.

Finding a Trade for Whatever Comes Next

We have written about Chipotle’s struggles previously. In that article, posted less than a month ago, we recommended a strategy known as a bear call spread. Specifically, for CMG, we recommended selling a July 21 $450 call for $2.75 and buying a July 21 $462.50 call for $1.40. That trade generated a credit of $135 on risk of $1,115.

Both of those options are now worthless. That means the trade delivered a return of about 12% for one month. It expires on Friday but could be closed for just a few cents ahead of expiration. Or, it can be allowed to expire.

Now, it is time to look for another trade in Chipotle.

The first step in identifying a trading opportunity is to look for when news can be expected from the company. CMG is expected to announce earnings on July 25, after the close. Historically, these announcements have had little impact on the stock. On average, CMG gains 1.1% in the week after the announcement.

It’s possible the earnings announcement will be routine but that seems unlikely. Management will need to address this latest problem while explaining how it will affect future earnings. You may remember that Chipotle used expensive promotions to get customers back last time.

Those efforts were finally paying off when this latest outbreak occurred. Management may need to continue with expensive promotion efforts or even find new ways to get customers back.

In addition, there is a question of what caused the latest problem. At a minimum, we should expect management to address whether food safety efforts adopted earlier are working. They should also be expected to discuss whether new efforts are needed.

There are a number of unknowns now and many of the unknowns will become known, at least to some degree, after the earnings report. This means it is likely the stock will make a significant move after the announcement.

A Long Iron Butterfly

The long iron butterfly strategy is useful when an investor is looking for a sharp move either up or down in the underlying stock during the life of the options. The trade delivers a profit if the underlying stock is outside the wings of the iron butterfly at expiration.

For the trade, the risks are known in advance and the profits are maximized if the stock makes a large move. The potential profits and risks are illustrated in the chart below which is from The Options Industry Council web site.

The long iron butterfly combines a short call at a higher exercise price, a long call and long put at a middle exercise price, and a short put at a lower exercise price. The upper and lower exercise prices, the wings of the butterfly, will be an equal distance from the middle exercise price which is the body of the butterfly. All of the options must share the same expiration date to limit the risk of the trade.

With earnings due on July 25, we want to use options that expire shortly after that. There are a number of weekly options available in CMG. Using options that expire on August 4 should minimize the cost of the trade and allow time for the market to move after the earnings announcement.

CMG closed on Wednesday at $373.16. To build the butterfly, we will use options near the closing price to form the body. There is an August 4 option with an exercise price of $377.50 that will work. We will then use options with exercise prices $5 away from that price to form the wings. The options are:

  • Short 1 CMG August 4 $372.50 call at about $13.75
  • Long 1 CMG August 4 $377.50 call at about $14.20
  • Long 1 CMG August 4 $377.50 put at about $13.70
  • Short 1 CMG August 4 $382.50 put at about $16.45

Each contract covers 100 shares so the premiums will need to be multiplied by 100 to find the cost of the trade. Buying and selling this combination of options will cost about $230. This is the maximum amount of risk on the trade.

The maximum potential gain on the trade is equal to the difference between the wings and the body of the trade less the premium paid. For this trade, the difference in the exercise price of the wings and body is $500 and the premium paid if $230. That means the maximum gain is $270.

Many brokers allow a trade like this to be opened using trading capital equal to the maximum risk on the trade, or $230 for this position. The maximum gain is equal to 117% of the amount risked.

This trade will deliver the maximum gain if CMG is above $382.50 or below $377.50 on August 4. Those prices are about 1.3% away from the current price of the stock. The probability of a price move of that size in this volatile stock is relatively high.

Once again, CMG may deliver a large gain on a small amount of capital as the stock struggles with news.