This Beaten Down Restaurant Could Be Ready to Deliver a 76% Gain
Trade summary: A bull call spread in Darden Restaurants, Inc. (NYSE: DRI) using the August $80 call option which can be bought for about $3.56 and the August $85 call could be sold for about $1.75. This trade would cost $1.81 to open, or $181 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 $181. The maximum gain is $319 per contract. That is a potential gain of about 76% based on the amount risked in the trade.
Now, let’s look at the details.
Darden Restaurants stock has been hit hard by the pandemic, as the Olive Garden owner has had to close many of its locations to dine-in customers as part of local lockdown protocols.
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J.P. Morgan, however, argues that the market is too pessimistic about the shares’ prospects.
Analyst John Ivankoe upgraded Darden to Overweight from Neutral and added $8 to his price target on the stock, to $82. The move comes following his recent conversations with management, including with CEO Gene Lee and Chief Financial Officer Rick Cardenas, which bolstered his confidence that the company is executing well throughout the crisis.
He writes that management “did not seem overly concerned about near-term sales trends as evidenced by several data sources showing a leveling off, as opposed to worsening sales trends.” He also agrees with Darden executives, as they see the Covid-19 threat largely fading by the end of 2021 (thanks to either a vaccine or effective treatment, or some kind of herd immunity), at which point consumers will resume dining at their locations in pre-pandemic levels.
Of course, that is nearly a year and a half away. Yet Ivankoe argues that the company isn’t just sitting idly by as it waits for the worst to pass.
“In the meantime, the company has taken an approach of restructuring menus and back-of-house store operations as a ‘once in a lifetime opportunity’ when changes can be made holistically and at-once versus the ‘incrementalism’ required when stores were previously operating well within historical parameters,” he writes.
His optimism about these changes leads him to raise his fiscal 2022 earnings estimate to $5.50, from $4.68; in addition, he notes that if Darden stock were able to return to more historical levels of profitability, the shares could easily trade at 14 times earnings, or $82 by the end of next year.
For now, the company is meeting customers where they are now, which includes delivery and pickup, and investors were pleased with the progress reflected in its most recent earnings report.
The chart below shows that the stock has been basing after a significant retracement of the bear market decline.
From a longer-term perspective, there is no resistance in the chart and a significant rally is possible based on technicals.
A Specific Trade for DRI
For DRI, 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 $80 call option can be bought for about $3.56 and the August $85 call could be sold for about $1.75. This trade would cost $1.81 to open, or $181 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 $181.
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 DRI, the maximum gain is $319 ($85- $80= $5; 5- $1.81 = $3.19). This represents $319 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $181 to open this trade.
That is a potential gain of about 76% 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 DRI 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.