Quarantine Explains This Possible Double-Digit Gain
Trade summary: A bull call spread in Roku, Inc. (Nasdaq: ROKU) using the April 17 $90 call option which can be bought for about $8.78 and the April 17 $95 call could be sold for about $6.69. This trade would cost $2.09 to open, or $209 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 $209. The maximum gain is $291 per contract. That is a potential gain of about 39% based on the amount risked in the trade.
Now, let’s look at the details.
Analyst comments were cited by Benzinga,
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“Loop Capital raised its rating on the streaming platform company, but lowered revenue estimates with an assumption that the sudden economic upheaval will lead to a drop in advertising.
Alan Gould upgraded Roku from Sell to Hold with a $68 price target.
Gould assumes Roku’s platform revenue will take less of a Coronavirus hit than many media companies, but said channel checks show advertising is likely to decline.
The outlook for growth remains, however, with Gould saying it may even get a boost as Americans stream more hours of content in quarantine.
“Assuming the economy rebounds by the fourth quarter, we estimate platform revenue will still continue to show impressive growth,” Gould wrote in the note, though he said the rate of growth could slow considerably, possibly to as low as 45% in 2020 from an estimated 73% last year.
The lower price of the stock is good, he said, noting the stock has dropped about in half since February.
Gould lowered his first-quarter revenue estimate to $292 million, below the $300 million lower end of guidance.
He said the second quarter will be the toughest for advertising, with recovery beginning in the third quarter.”
A short term bottom appears to be forming in the chart with a spike low followed by a pivot higher. The spike is seen in the daily chart below.
The weekly chart shows an up tick in momentum. Stochastics, a popular momentum indicator, is shown at the bottom of the chart. Similar patterns in stochastics have coincided with at least brief up turns in the price of the stock.
While there is a probability of higher prices in ROKU, there is still a risk of a broad market down turn or even a broad market collapse. In the current environment, strategies focused on risk could be the best tools for gaining exposure to the market.
A Specific Trade for ROKU
For ROKU, the April 17 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.
An April 17 $90 call option can be bought for about $8.78 and the April 17 $95 call could be sold for about $6.69. This trade would cost $2.09 to open, or $209 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 $209.
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 ROKU the maximum gain is $2.91 ($95- $90= $5; $5 – $2.09 = $2.91). This represents $291 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $209 to open this trade.
That is a potential gain of about 39% 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 ROKU 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 has 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.