This Pot Stock Could Deliver a 94% Gain to Investors
Trade summary: A bull call spread in Canopy Growth Corporation (NYSE: CGC) using the September $17.50 call option which can be bought for about $1.91 and the September $20 call could be sold for about $1.06. This trade would cost $0.85 to open, or $85 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 $85. The maximum gain is $165 per contract. That is a potential gain of about 94% based on the amount risked in the trade.
Now, let’s look at the details.
Barron’s covered CGC’s earnings announcement.
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“The company reported a fiscal first-quarter net loss of 30 Canadian cents per share ($US0.22), beating Wall Street’s consensus estimate that called for a net loss of 43 Canadian cents per share, according to FactSet.
The company’s sales of C$110.4 million also beat expectations at C$98.6 million, and were up 22% year-over-year.”
The stock was up on the news.
CGC engages in the production, distribution, and sale of cannabis for recreational and medical purposes primarily in Canada, the United States, Germany, and the United Kingdom. The company’s products include dried cannabis flowers, oils and concentrates, and softgel capsules.
It offers its products under the Tweed, Quatreau, Deep Space, Spectrum Therapeutics, First & Free, TWD, This Works, BioSteel, DNA Genetics CraftGrow, Tokyo Smoke, DOJA, Van der Pop, and Bean & Bud brands.
The company also provides growth capital and a strategic support platform that pursues investment opportunities in the global cannabis sector.
Barron’s continued, “The company’s Canadian recreational pot sales were C$44.2 million, compared with consensus estimates that called for C$41 million. Canadian and International medical sales of C$13.9 million and C$20.2 million were below consensus estimates. The “all other revenue” category brought in C$32.1 million.
“We’re proud of our strong first-quarter performance, despite unprecedented volatility and uncertainty in the market and across the globe,” CEO David Klein said in the news release. “We grew our revenue year-over-year and are seeing market share improvement, notably achieving number one market share in cannabis-infused beverages in the Canadian market.”
Klein, who was previously chief financial officer at brewer and Canopy’s controlling shareholder Constellation Brands (STZ), took over as Canopy’s chief in January following disappointing losses in 2019. Canopy CFO Mike Lee noted the company cut its expenses and cash burn in the quarter, including layoffs that have reduced headcount by more than 18% since the start of 2020.
MKM Partners’ Bill Kirk pointed to the company’s efforts to cut back on expenses, which helped offset what he called a lighter than expected adjusted gross margin at 7%.
“That said, we still have difficulty envisioning Canopy growing into its expense structure,” he wrote, pointing to an industry wide supply glut and consumer trends toward cheaper, lower-margin pot. He notes legislative changes and industry-wide excitement could provide upside to shares.”
CGC appears to be bouncing off a base and could continue higher as investors return to the marijuana sector.
A Specific Trade for CGC
For CGC, the September 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 September $17.50 call option can be bought for about $1.91 and the September $20 call could be sold for about $1.06. This trade would cost $0.85 to open, or $85 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 $85.
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 CGC, the maximum gain is $165 ($20- $17.50= $2.50; 2.50- $0.85 = $1.65). This represents $165 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $85 to open this trade.
That is a potential gain of about 94% 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 CGC 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.