Risks Outweigh Rewards But This Strategy Could deliver an 87% Gain Despite That Problem
Trade summary: A bull call spread in Deere & Company (NYSE: DE) using the March 20 $180 call option which can be bought for about $3.45 and the March 20 $185 call could be sold for about $1.71. This trade would cost $1.74 to open, or $174 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 $174. The maximum gain is $326 per contract. That is a potential gain of about 87% based on the amount risked in the trade.
Now, let’s look at the details.
Barron’s explained the news, noting that shares of Deere surged “after the heavy- machinery giant surprised Wall Street with a quarterly profit of $1.63 a share, beating estimates of $1.27. The company said easing of trade tensions has made farmers more confident, adding to demand for heavy equipment.”
Benzinga presented some details on how one analyst viewed the news.
“Bank of America analyst Ross Gilardi attributed most of the bottom-line outperformance to taxes, which contributed 27 cents per share, and to operating profit, which came in 3% ahead of consensus.
He also expressed disappointment that earnings before interest and tax declined 60% in the Construction and Forestry segment while cost and freight margins came in 3.5 percentage points below Bank of America’s forecasts.
“The good news of the quarter is that Ag & Turf margins of 8.4% (BofA 6.2%) were up 110 basis points YoY on a 4% decline in sales, snapping a 6 quarter streak of down margins for that segment, boosted by 3% pricing and cost declines that more than offset a $78 million voluntary separation headwind,” Gilardi wrote in a report.
However, he anticipates a rough-enough performance in the near term to warrant an Underperform rating.
“We were honestly a little surprised that Deere did not reduce Europe and South America given weak trends, though Deere did not acknowledge a soft start to the year in Brazil,” Gilardi wrote.
Bank of America maintained an Underperform rating on Deere with a $150 price target.”
This target is below the current price of the stock indicating that DE carries significant risk. But the stock broke out of a trading range which is bullish. The trading range provides a price target about $10 above the current price, which is just about one third of the risk in the trade based on fundamentals.
When the chart says buy and the fundamentals say sell, many traders look for the next opportunity. A different approach is to use a spread trade that offers potential upside while strictly limiting the downside risk.
A Specific Trade for DE
For DE, the March 20 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 March 20 $180 call option can be bought for about $3.45 and the March 20 $185 call could be sold for about $1.71. This trade would cost $1.74 to open, or $174 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 $174.
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 DE the maximum gain is $3.26 ($185- $180= $5; $5 – $1.74 = $3.26). This represents $326 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $174 to open this trade.
That is a potential gain of about 87% in DE 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 DE 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.