This Could Be a Safe Trade in the Airline Industry
Airlines are volatile and the industry can be rocked by news, such as news about Boeing’s aircraft design or oil price concerns as tensions fare in the Middle East. The Boeing story, for example, is having an impact on Southwest Airlines (NYSE: LUV).
According to Reuters, “Once global regulators clear Boeing Co’s 737 MAX to fly again after deadly crashes, airlines which have put their fleets into mechanical hibernation since March will scramble to begin the biggest ungrounding effort in history.
Quickly reintegrating Boeing’s 737 MAX, a fast-selling model because of its fuel efficiency, longer range, and passenger capacity, is crucial for optimizing airlines’ routes and improving margins after having to cancel thousands of flights.
Global airlines have warned of a major hit to profits due to the mid-March grounding of the MAX following two fatal crashes.
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International regulators are meeting on May 23 to review Boeing software and training plans, though doubts remain over how quickly foreign authorities will clear new flights.
In the United States, following regulatory approval of a Boeing software fix and new training, airlines will have to run through an FAA-approved checklist, industry officials say.
Such work, which will vary by operator, includes cycling the engines, changing and filling fluids, removing covers from the engines and running routine electrical and hydraulics checks.
Each airline will also have to upload Boeing’s new software for an anti-stall system implicated in the crashes and complete additional pilot training.
Jason Goldberg, spokesman for the Allied Pilots Association, said it will take about a week to prepare American Airline Group Inc’s MAX fleet to fly, not counting the extra training.
“While the planes are in storage there is of course maintenance that can be done. But as far as steps to put it back into service, none of the work is going to be done until the aircraft is cleared to fly.”
Airlines likely halted standard daily systems checks while the planes were in storage, said one former Boeing test pilot. Similar to a modern car, when mechanics restore power to the aircraft, built-in testing equipment runs checks on sensors gauging the health of aircraft systems from hydraulics and to fuel – known as a ‘BITE’ test – that would signal failures.
Another issue is pilot training.
Boeing said on Thursday it was in the process of submitting a plan on pilot training to the U.S. Federal Aviation Administration (FAA) for approval, after which each airline will develop its own FAA-approved training program.
Southwest Airlines Co, the world’s largest MAX operator, has agreed a 30-day window with its 10,000 pilots to implement new MAX training, said Mike Trevino, spokesman for Southwest Airlines Pilots Association.
“If it’s computer-based training, that won’t be difficult to deploy. The pilots can do it at home,” he said.
A draft report by an FAA-appointed board of pilots, engineers and other experts concluded that pilots only need additional computer-based training, rather than simulator time, though other regulators and some pilot groups have argued for more.
Southwest is expected to upload the new software at a facility in the California desert where its 34 MAX jets are parked, while American Airlines is expected to install the software at its Tulsa, Oklahoma maintenance facility.
Southwest and American have scheduled MAX flights as of Aug. 6 and Aug. 20 respectively. If the jets are not cleared to fly by then, the airlines will be forced to again cancel more than 100 daily flights.”
LUV has been in a trading range for the past few weeks as traders assess the news.
In the longer term, the range can be seen as part of a down trend.
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 LUV
For LUV, we could sell a June 21 $52.50 call for about $1.35 and buy a June 21 $55 call for about $0.50. This trade generates a credit of $0.85, 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 $85. The credit received when the trade is opened, $85 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $165. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($85).
This trade offers a potential return of about 51% 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 LUV is below $52.50 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 $165 for this trade in LUV.