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This Trade Could Deliver Income of 38% In Less Than Two Months

This Trade Could Deliver Income of 38% In Less Than Two Months

Trade summary: A bear call spread in Tyson Foods, Inc. (NYSE: TSN) using June $52.50 call options for about $5.50 and buy a June $57.50 call for about $2.60. This trade generates a credit of $2.90, which is the difference in the amount of premium for the call that is sold and the call.

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  • In this trade, the maximum risk is about $210. 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 ($290). This trade offers a potential return of about 38% of the amount risked.

    Now, let’s look at the details.

    Bloomberg reported that TSN fell “after the top U.S. meat supplier forecast lower output and higher costs, with the meat-industry’s outlook so murky it couldn’t offer annual financial guidance.”

    TSN daily chart

    The inability to offer guidance is becoming an increasingly common problem for large companies. It was recently reported that,

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  • “Predicting the future — known in the business world as providing financial guidance to investors — has always fallen somewhere between sophisticated modeling on one end and a fool’s errand on the other.

    This year, company forecasts jumped from one to the other overnight as the COVID-19 pandemic made a mockery of financial projections and left investors wondering how much of what they thought they understood about their holdings still applies.

    By early April, public companies began officially withdrawing their previously issued guidance for the year.

    “It is impossible to confidently forecast the immediate future of our business,” Leroy Ball, president and CEO of Koppers Holdings, told analysts on April 27 as the maker of wood products and chemicals pulled its guidance and suspended issuing any future forecasts “until further notice.”

    In the case of TSN, “an unprecedented wave of plant shutdowns and slowdowns because of the coronavirus is set to continue, resulting in higher operating costs and lower volume for the rest of fiscal 2020, Tyson said in a statement on second-quarter earnings, which missed estimates amid derivative losses.

    That may mean “short-term outages” in availability for some meat products at grocery stores.

    While the pandemic has meant higher retail volume, that won’t be enough to offset food-service losses. About 40% of Tyson’s sales come from the restaurant business

    “Due to the uncertainty of the COVID-19 impacts to our operations, we are currently unable to provide segment adjusted operating margin guidance,” Chief Executive Officer Noel White said.

    As thousands of U.S. meat-plant workers fall ill, and some die, processors are wrestling with how to keep consumers supplied with protein while also protecting their labor force. The closures mean beef and pork prices are surging, and farmers are destroying tens of thousands of animals as oversupply pushes down livestock prices.

    The U.S. government stepped in last week, with President Donald Trump invoking the Defense Production Act to keep plants running. But that won’t be a quick fix and unions say the measure puts workers in danger. Tyson said absent workers and closings of facilities were reducing what would otherwise be a strong margin environment.

    “The major challenge we face is the availability of team members to operate our production facilities as our production facilities are experiencing varying levels of absenteeism,” the company said in commentary filed with the Securities and Exchange Commission.

    The long-term chart shows that TSN undercut important support and downside risks are now relatively high in the stock.

    TSN weekly chart

    Buying 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 TSN

    For TSN, we could sell a June $52.50 call for about $5.50 and buy a June $57.50 call for about $2.60. This trade generates a credit of $2.90, 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 $290. The credit received when the trade is opened, $290 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade is about $210. 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 ($290).

    This trade offers a potential return of about 38% 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 TSN 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 $210 for this trade in TSN.

    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.

    bear call spread

    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.

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