This Deal Could Lead to a Triple Digit Short Term Gain
Trade summary: A bull call spread in Nelnet, Inc. (NYSE: NNI) using the December $65 call option which can be bought for about $4.85 and the December $70 call could be sold for about $3.55. This trade would cost $1.30 to open, or $130 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 $130. The maximum gain is $370 per contract. That is a potential gain of about 184% based on the amount risked in the trade.
Now, let’s look at the details.
PR Newswire carried the announcement that NNI entered into agreements to partner with SDC Capital Partners, LLC in which funds managed by SDC will make a $197 million equity investment in ALLO Communications, LLC for an approximately 48% ownership stake in ALLO.
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The collaboration will provide ALLO with capital to continue expanding its all-fiber-optic network and superior service offerings into additional communities in the Midwest. The investment by SDC is expected to close in October 2020, subject to certain closing conditions.
“Exceptional communications solutions for business, government, and residential customers have become even more important during the pandemic,” said Brad Moline, President of ALLO.
“Communities across the Midwest are clamoring for better connectivity. We are excited to continue to deliver to all of our customers the exceptional local service that ALLO has provided for more than 15 years. With SDC, Nelnet, and our proven team of 500+ associates, we can transform how even more communities work, learn, and play.”
Since 2004, ALLO has been overbuilding communities with modern fiber networks, creating GIG communities. As of June 30, 2020, ALLO’s team served more than 53,000 residential subscribers and thousands of businesses as well as governmental entities across 12 communities.
“ALLO has established itself as a leading provider of fiber-to-the-premise services in Nebraska and Colorado and we are thrilled to support its growth alongside Nelnet,” said Clinton Karcher, Principal at SDC.
“We are firm believers that serving customers with high-quality, state-of-the-art network infrastructure and white glove customer service will result in long-term success, and ALLO embodies both of these characteristics.”
“We are excited to partner with SDC to accelerate ALLO’s growth,” said Terry Heimes, Chief Operating Officer of Nelnet.
“SDC’s investment will provide the necessary capital to build out fiber networks primarily in Nebraska and Colorado and help communities and businesses meet the increasing demand for high-speed, reliable broadband with the best and latest technologies.
SDC’s deep sector experience and relationship network make it the ideal long-term partner for ALLO. Over the last five years, we have seen firsthand the value ALLO’s technology and service bring to a community. We look forward to supporting their long-term success alongside SDC.”
The proceeds to be obtained by ALLO from the transaction, together with new third-party debt financing expected to be obtained by ALLO, will be used to fund ALLO’s expansion and partially redeem outstanding senior preferred interests held by Nelnet. Additional information about Nelnet’s agreements with SDC and ALLO will be provided in a Current Report on Form 8-K to be filed by Nelnet with the Securities and Exchange Commission on the date of this press release.
Nelnet acquired 92.5 percent of the outstanding equity and membership interests of ALLO on December 31, 2015. Since that transaction, Nelnet has invested significant additional capital in ALLO to build networks in Lincoln, Hastings, Imperial, and Norfolk, Nebraska and Fort Morgan and Breckenridge, Colorado.
The stock was up on the news.
A breakout could complete a broad consolidation that points to a target above $85.
A Specific Trade for NNI
For NNI, the December 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 December $65 call option can be bought for about $4.85 and the December $70 call could be sold for about $3.55. This trade would cost $1.30 to open, or $130 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 $130.
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 NNI, the maximum gain is $370 ($70- $65= $5; 5- $1.30 = $3.70). This represents $370 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $130 to open this trade.
That is a potential gain of about 184% 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 NNI 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 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.