This Trade Has $57 in Risk and a Potential Gain of 238%
Trade summary: A bull call spread in Rackspace Technology, Inc. (Nasdaq: RXT) using the September $20 call option which can be bought for about $2.27 and the September $22.50 call could be sold for about $1.70. This trade would cost $0.57 to open, or $57 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 $57. The maximum gain is $193 per contract. That is a potential gain of about 238% based on the amount risked in the trade.
Now, let’s look at the details.
Bloomberg reported “Amazon.com Inc. is in talks to acquire a minority stake in Rackspace Technology Inc., according to a person familiar with the matter, sending Rackspace’s shares surging.”
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Bloomberg continued, “Majority owned by private-equity firm Apollo Global Management, Rackspace was among pioneers of what would come to be called cloud computing, providing rented data storage and processing power that customers access over an internet connection.
Amazon, through its Amazon Web Services unit, upended that business, growing into the leader in such computing infrastructure services. Rackspace is now both a partner and competitor to Amazon.
Rackspace had a disappointing initial public offering last month where it raised $704 million in a U.S. listing but priced at the bottom of the marketed range.
Rackspace today markets itself in part as a technology provider able to help businesses make use of cloud-computing services from AWS, Microsoft Corp. and Alphabet Inc.’s Google.”
Rackspace Technology is a multi-cloud technology services company. The company designs, builds and operates cloud environments across technology platforms.
The company’s segments include Multicloud Services, Apps & Cross Platform and OpenStack Public Cloud. The Multi cloud Services segment includes public and private cloud managed services offerings, as well as professional services related to designing and building multi cloud solutions and cloud-native applications.
The Apps & Cross Platform segment includes managed applications, managed security and data services, as well as professional services related to designing and implementing application, security and data services.
OpenStack Public Cloud enables to run applications on a public cloud that is built on open-source technology. It delivers professional services across its entire portfolio, including multi cloud solutions, applications, security and data.
Of course, the news could just ne a rumor. If there is no deal, the stock price could fall. This is especially true since investors showed they were not enthusiastic about the stock’s prospects after its initial public offering.
For these reasons, the stock could be considered risky after the sharp run up in price. Options can limit the risk and provide significant upside potential.
A Specific Trade for RXT
For RXT, 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 $20 call option can be bought for about $2.27 and the September $22.50 call could be sold for about $1.70. This trade would cost $0.57 to open, or $57 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 $57.
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 RXT, the maximum gain is $193 ($22.50- $20= $2.50; 2.50- $0.57 = $1.93). This represents $193 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $57 to open this trade.
That is a potential gain of about 238% 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 RXT 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.