Traders Could Enjoy a 144% Gain in This Water Company
Trade summary: A bull call spread in Xylem Inc. (NYSE: XYL) using the August $75 call option which can be bought for about $2.60 and the August $80 call could be sold for about $1.15. This trade would cost $1.45 to open, or $145 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 $145. The maximum gain is $355 per contract. That is a potential gain of about 144% based on the amount risked in the trade.
Now, let’s look at the details.
XYL, a global water technology company [recently] announced that for the quarter ended June 30, 2020, it expects revenue declines of approximately -14 percent on a reported basis, and -12 percent organically, versus previous guidance of -20 to -30 percent, according to Business Wire.
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Traders reacted well to the news.
The news release noted, “Xylem expects second quarter EPS in the range of $0.15 to $0.17 on a reported basis, and $0.37 to $0.39 on an adjusted basis, excluding restructuring, realignment and special items.
Xylem further announced it signed two milestone deals during the second quarter. The Company won a large-scale irrigation project in the Telangana region of India, worth approximately $115 million, making it the largest deal Xylem has signed in the country, to date. Revenue from the project is expected to be recognized over the next two to three years, starting late in the fourth quarter of 2020.
Separately, in the United Kingdom, Xylem will be deploying smart metering, software and network solutions for Anglian Water. The $90 million contract will see implementation across Anglian’s service area, which covers a large portion of the east of England, with revenue recognition expected over the next five years, beginning late in the fourth quarter of 2020.
“The preliminary second quarter results demonstrate that our team, across the world, has continued to serve our customers well, particularly those delivering essential services in their communities, despite the difficulties of COVID-19,” said Patrick Decker, president and CEO of Xylem. “While we are still seeing considerable impact from the pandemic, we’re pleased we have been able to navigate the headwinds so far, setting a better-than-anticipated pace.
“We are fully operational across our manufacturing network, and are in a solid position to weather the uncertainties of this changeable and challenging environment,” continued Decker. “The large deals we are winning – both in developed and emerging markets – are proof that large-scale projects, and the implementation of transformational technologies, are continuing to move ahead and that Xylem is well positioned to benefit from that momentum over the longer term. We look forward to reporting full results for the quarter in a few weeks’ time.”
XYL appears to have found support and could be set up for a rally towards recent highs.
A Specific Trade for XYL
For XYL, the August 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.
An August $75 call option can be bought for about $2.60 and the August $80 call could be sold for about $1.15. This trade would cost $1.45 to open, or $145 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 $145.
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 XYL, the maximum gain is $355 ($80- $75= $5; 5- $1.45 = $3.55). This represents $355 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $145 to open this trade.
That is a potential gain of about 144% 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 XYL 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.