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Volatility Creates a Double-Digit Income Opportunity

Volatility Creates a Double-Digit Income Opportunity

Trade summary: A bear call spread in ABIOMED, using February 21 $170 call options for about $7.70 and buy a February 21 $175 call for about $5.50. This trade generates a credit of $2.20, 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 $280. 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 ($220). This trade offers a potential return of about 78% of the amount risked.

    Now, let’s look at the details.

    ABIOMED, Inc. (Nasdaq: ABMD) recently announced earnings and Zacks reported that the company reported “earnings per share (EPS) of $1.03. The figure rose 27.2% year over year. The company’s revenues came in at $205 million.

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    In the quarter under review, gross profit totaled $170.1 million, up 12% year over year. Gross margin in the quarter was 83% of net revenues, down 60 basis points (bps) year over year. Research & Development (R&D) costs grossed $24 million, up 5.5% year over year.

    Operating income totaled $60.2 million, up 19.6% on a year-over-year basis. Operating margin was 29.4%, up 170 bps.

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  • ABIOMED’s balance sheet is debt free. The company ended the fiscal second quarter with $551.3 million of cash and marketable securities.

    For fiscal 2020, ABIOMED maintains total revenue projection in the range of $885-$925 million, calling for an increase of 15-20% year over year.”

    ABMD’s primary product is Impella, a family of medical devices used for temporary ventricular support in patients with depressed heart function. The company reported US revenue of $172 million for this product in the most recent quarter, a year over year increase of 9%.

    In the earnings announcement, management noted that patient usage of the heart pumps increased 14% in the quarter, with 62 new sites opened in the country.

    Outside the United States, Impella product revenues totaled $33 million, a 40% YoY, largely due to a 135% increase in Japan.

    While the news was mostly good, traders seemed unimpressed and the stock remains in a volatile trading range.

    ABMD daily chart

    The stock is now near its 52-week low and the fact that earnings failed to push the stock away from this low is potentially bearish. The weekly chart shows a large topping pattern formed over the past three years and a break of support could send the price down substantially.

    ABMD 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 ABMD

    For ABMD, we could sell a February 21 $170 call for about $7.70 and buy a February 21 $175 call for about $5.50. This trade generates a credit of $2.20, 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 $220 The credit received when the trade is opened, $220 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade is about $280. 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 ($220).

    This trade offers a potential return of about 78% 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 ABMD is below $170 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 $280 for this trade in ABMD.

    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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