This Troubled Company Might Deliver a 127% Gain
Trade summary: A bear call spread in Wayfair Inc. (NYSE: W) using March 20 $60 call options for about $6.60 and buy a March 20 $65 call for about $3.80. 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.
Barron’s recently highlighted Wayfair’s struggle to capture investors’ attention. The company is a fast-growing online furniture retailer but profitability is a concern. This can be seen in the stock price.
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The most recent gap down occurred as the company reported earnings, “The company said [recently] it brought in $2.53 billion in sales and lost $3.54 per share. Analysts expected $2.53 billion in sales and a loss of $2.64 per share, according to Factset.
Perhaps most worrying for investors, sales growth in the quarter was far outpaced by expense growth, with the former up 26% year over year, but the latter rising 44%.
Earlier in February, the company said it was cutting 500 jobs, about 3% of its workforce. Explaining the cuts, co-founder and Chief Executive Niraj Shah wrote an email to staff in which he said, “ultimately every company needs to be self-financing,” The Wall Street Journal reported.
On a conference call with analysts, Shah said that the company would work to slow growth in costs, particularly for advertising. But the company said that even with that cost discipline, it doesn’t expect to begin delivering reliable profits until next year.”
This latest news pushed the stock below support near $75 that had held since 2018. The next important support level is near $25 and falling to that level would reverse more than three years’ worth of gains.
Given the stock’s precarious position on the chart, it is reasonable to expect additional weakness. Even if the stock is able to stop following, the possibility of a strong rally appears to be remote. Fundamentals, including the absence of profits and rising expenses, fail to inspire the confidence of bulls.
Momentum is strong and adds to the bearish case for the stocks. A short trade could be the best course of action for investors interested in the stock.
While weakness is expected, 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 W
For W, we could sell a March 20 $60 call for about $6.60 and buy a March 20 $65 call for about $3.80. 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 W is below $60 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 W.
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.