This Chinese Coffee Company’s Weakness Could Boost Investors
The news has been bearish for many Chinese stocks lately. Bloomberg recently reported,
Luckin Coffee Inc. (Nasdaq: LK), the chain trying to take on Starbucks Corp. in China, plunged the most since its U.S. trading debut in May after it issued earnings for the first time as a public company.
Luckin, which is based in China and listed in the U.S, said it was taking a hit from trade tensions and the slowing Chinese economy as it races to open stores and burns cash to build market share in China’s nascent coffee market.
The shares sank 17% on the news but the shares were up 44% from the $17-a-share initial public offering price prior to the earnings announcement.
Despite the share plunge, which came on a day when global recession fears were weighing down markets, Luckin is on track to start breaking even at its individual locations this year, according to Chief Financial Officer Reinout Schakel.
He added that the company could benefit from its lower prices if trade tensions and the weakening Chinese economy continue to hit consumers.
“With the proposition we have around affordability, we’re well-positioned to weather that storm,” Schakel said in an interview.
Luckin posted a net loss of 681.3 million yuan ($97 million). Revenue was 909.1 million yuan, compared with analysts’ estimates of 909 million.
It is seeking to overtake Starbucks in China by opening more stores in two years than the industry giant has in 20 years.
Investors have questioned the Xiamen, China-based company’s strategy of sacrificing profits to lure new customers with discounts when the Chinese economy is growing at its slowest pace in three decades, while a prolonged U.S.-China trade war damps consumer confidence.
China is becoming an increasingly important market for coffee retailers as the country’s middle-class tea drinkers develop a taste for java.
Luckin has an uphill battle, as it claimed only 2.1% of the market last year, while Starbucks has more than a 50% share and also plans to continue its rapid expansion by opening one store every 15 hours.
Luckin’s store count may be on track to overtake Starbucks this year, but the vast majority of its outlets are kiosks for delivery and takeaway, unlike the plush hang out style of spaces at Starbucks.
A Trading Strategy To Benefit From Weakness
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.
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.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in LK
For LK, we could sell a September 20 $17.50 call for about $2.90 and buy a September 20 $20 call for about $1.55. This trade generates a credit of $1.35, 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 $135. The credit received when the trade is opened, $135 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $365. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($135).
This trade offers a potential return of about 36% 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 LK is below $17.50 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 $365 for this trade in LK.