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Post-Disaster Trading

Post-Disaster Trading

Disasters can be natural or man-made. When the disaster is man made it is often the result of a mistake. That mistake can have devastating consequences for investors. This could be unfolding right now in the case of Pacific Gas & Electric Co. (NYSE: PCG).

The stock has been in a free fall since news of the company’s role in recent California fires broke.

PCG daily chart

Many analysts are speculating the company will need to declare bankruptcy to handle the costs and liabilities of the fires.

Options Might Not Save the Company

According to a recent Bloomberg article, the fate of PG&E Corp. isn’t limited to bankruptcy. The embattled California utility owner could also face a shakeup, breakup, bailout or takeover as it grapples with billions of dollars in potential liabilities from wildfires.

What happens next hinges largely on state lawmakers, regulators and investigators probing whether the company’s equipment sparked Northern California wildfires in 2017 and 2018 that together killed more than 100 people. Here’s an overview of the options:

The California Public Utilities Commission has embarked on a sweeping review of the company in the aftermath of the fires, examining its safety culture, structure and governance.

On Jan. 4, PG&E said it was searching for new directors who could bring “fresh perspectives” on safety and operations. A state lawmaker who co-wrote a law last year to help PG&E pay for wildfire liabilities said a leadership shakeup should also include changes “in the executive suite.”

As part of that review, regulators are mulling whether the structure of PG&E itself needs overhauling. That could include carving the utility owner into smaller regional subsidiaries or converting it into a government-owned company.

In response, PG&E recently said it’s “reviewing structural options.”

National Public Radio reported that the utility owner is weighing the sale of its natural gas business to cover billions of dollars in potential liabilities from the blazes, citing a senior company official and a former employee. PG&E didn’t comment on that report.

California lawmakers are considering introducing a bill to help PG&E absorb liabilities from the 2018 fires. The measure could extend legislation that lets PG&E issue bonds to pay off costs tied to 2017 wildfires to include last year’s Camp Fire, the deadliest in state history.

PG&E is considering whether to file for bankruptcy as soon as February, people familiar with the situation said. Analysts estimate the company could face upward of $30 billion in liabilities from the 2017 and 2018 fires.

Evercore ISI’s Greg Gordon said it “could face a liquidity crisis by mid-to-late ’19.” PG&E has declined to comment.

California Public Utilities Commission chief Michael Picker said in November that he couldn’t imagine allowing the state’s largest utility to go into bankruptcy. One lawmaker said Friday that PG&E may be raising at the prospect of a Chapter 11 filing to pressure lawmakers into bailing out the company.

The stock’s trend is now clearly down.

PCG weekly chart

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.

bear call spread

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.

A Bear Call Spread in PCG

For PCG, we could sell a February 15 $20 call for about $2.30 and buy a February 15 $24 call for about $0.80. This trade generates a credit of $1.50, 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 $150. The credit received when the trade is opened, $150 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $250. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($150).

This trade offers a potential return of about 60% 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 PCG is below $20 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 $250 for this trade in PCG.

These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.