Tesla’s Not the Only Car Company. This One Offers a 63% Gain.
Trade summary: A bull call spread in Lithia Motors, Inc. (NYSE: LAD) using the August $230 call option which can be bought for about $11.20 and the August $240 call could be sold for about $7.40. This trade would cost $3.80 to open, or $380 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 $380. The maximum gain is $620 per contract. That is a potential gain of about 63% based on the amount risked in the trade.
Now, let’s look at the details.
Lithia Motors, Inc. offers approximately 30 brands of new vehicles and all brands of used vehicles in about 150 stores in the United States and online at Lithia.com, DCHauto.com and CarboneCars.com.
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Its Domestic segment consists of retail automotive franchises that sell new vehicles manufactured by Chrysler, General Motors and Ford. Its Import segment consists of retail automotive franchises that sell new vehicles manufactured primarily by Honda, Toyota, Subaru, Nissan and Volkswagen.
Its Luxury segment consists of retail automotive franchises that sell new vehicles manufactured primarily by BMW, Mercedes-Benz and Lexus.
The franchises in each segment also sell used vehicles, parts and automotive services, and automotive finance and insurance products.
LAD recently reported earnings. Traders seemed to like the results.
According to Business Wire,
The company reported “second quarter 2020 net income per diluted share was $3.38, a 29% increase from $2.63 per diluted share reported in the second quarter of 2019.
Adjusted second quarter 2020 net income per diluted share was $3.72, a 26% increase compared to adjusted net income of $2.95 per diluted share in the same period of 2019.
Second quarter 2020 net income was $78 million, a 26% increase compared to net income of $62 million in the same period of 2019. Adjusted second quarter 2020 net income was $86 million, a 23% increase compared to adjusted net income of $69 million for the same period of 2019.
Second Quarter-over-Quarter Operating Highlights:
- Same store new vehicle sales decreased 23.5 %
- Same store used vehicle retail sales increased 0.5%
- Same store F&I per unit increased 9.4% to $1,590
- Same store total gross profit per unit increased 11.4% to $4,030
- SG&A as a percentage of gross profit improved 540bps to 64.7%
“The strong sequential improvements throughout the quarter, coupled with our stores’ responsiveness to the current environment, led us to the highest quarterly adjusted earnings per share in our company’s history,” said Bryan DeBoer, President and CEO.
“This record performance illustrates the massive opportunity that exists within our $2 trillion industry that we are unlocking through continued growth and the activation of our ecommerce digital home solutions.”
The news pushed the stock out of an extended trading range and led to new highs.
A Specific Trade for LAD
For LAD, the August 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 August $230 call option can be bought for about $11.20 and the August $240 call could be sold for about $7.40. This trade would cost $3.80 to open, or $380 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 $380.
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 LAD, the maximum gain is $620 ($240- $230= $10; 10- $3.80 = $6.20). This represents $620 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $380 to open this trade.
That is a potential gain of about 63% 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 LAD 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 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.