This Pandemic Trade Might Not Work As Many Suspected
Trade summary: A bear call spread in The Kroger Co. (NYSE: KR) using October $30 call options for about $3.27 and buy an October $35 call for about $0.47. This trade generates a credit of $2.80, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $220. 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 ($280). This trade offers a potential return of about 127% of the amount risked.
Now, let’s look at the details.
KR has been one of the winners in the market this year as the Covid-19 pandemic pushed people into the grocery store. The stock has made a significant move since last summer and volatility increased this year as the pandemic created panic among consumers.
Barron’s recently reported that Bank of America Merrill Lynch is warning that the good times may not last.
“analyst Robert Ohmes lowered his rating on [the stock] to Neutral from Buy, and lowered his price target by $2, to $40.
While he believes that the company will continue to benefit as more people order groceries online, he thinks “momentum is slowing from Kroger’s omnichannel initiatives, and the buildout and scaling of [e-commerce supermarket partner] Ocado network is still likely a long way out in terms of proving the strategy’s efficacy as a long-term delivery solution in the U.S.”
Kroger and other food retailers saw big gains from pantry-stocking this spring, when the Covid-19 crisis first took hold in the U.S. Yet Ohmes worries that this means tough comparisons are waiting for the company next year. He also thinks higher profits for the industry will start to moderate later this year.
Ohmes was more bullish after the company’s previous report, in June. Yet while the macro backdrop for supermarkets looks supportive, expectations have only gotten higher for the industry in recent months. In addition, he’s concerned about rising competition from deep-pocketed players like Walmart (WMT) and Amazon.com’s (AMZN) Whole Foods Market.
Groceries were one of the last areas of retail where consumers resisted online shopping, although the pandemic finally broke down that resistance for some. And while this trend will likely have legs post-Covid, analysts are split on how much Kroger can benefit.
For his part, Ohmes thinks investors will need patience to see meaningful returns from Kroger’s partnership with the British company Ocado.”
The longer-term chart using weekly data shows that the stock could be in a topping pattern and a decline is possible.
To benefit from a decline, traders could short the stock. Shorting shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for KR
For KR, we could sell an October $30 call for about $3.27 and buy an October $35 call for about $0.47. This trade generates a credit of $2.80, 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 $280. The credit received when the trade is opened, $280 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $220. 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 ($280).
This trade offers a potential return of about 127% 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 KR is below $30 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 $220 for this trade in KR.
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.