Weather Could Create a High-Income Trading Opportunity
Hurricanes and other natural disasters tend to wreak havoc and the tragedy associated with these events should never be minimized. In addition to the human toll of these disasters, there is also a financial toll. That financial toll can never be ignored by investors.
With Dorian causing damage in the southern United States and in the Caribbean, there are a number of peoples and companies that are suffering. Among those, as Biz Journals reported, is Delta Air Lines Inc. (NYSE: DAL) which said that as Hurricane Dorian develops, the airline has added 930 seats to the normal flight schedule across six flights between Hartsfield-Jackson Atlanta International Airport and Florida.
The airline has also expanded its capped fares to include flights between 14 southeastern cities in Florida and southern Georgia. The caps range between $299 and $799.
DAL provides scheduled air transportation for passengers and cargo throughout the United States and across the world.
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The company’s route network is centered around a system of hub, international gateway and airports that the Company operates in Amsterdam, Atlanta, Boston, Detroit, London-Heathrow, Los Angeles, Minneapolis-St. Paul, New York-LaGuardia, New York- John F Kennedy International Airport, Paris-Charles de Gaulle, Salt Lake City, Seattle and Tokyo-Narita.
Each of these operations includes flights that gather and distribute traffic from markets in the geographic region surrounding the hub or gateway to domestic and international cities and to other hubs or gateways.
The company’s route network includes its international joint ventures, its alliances with other foreign airlines, its membership in SkyTeam and agreements with multiple domestic regional carriers that operate as Delta Connection.
Hurricanes have been costly for the Atlanta-based airline over the past two years. Hurricane Florence, which ravaged the Carolinas last September, involved an estimated $30 million pre-tax hit, while 2017’s Hurricane Irma took an even more massive bite out of Delta’s bottom line — approximately $120 million.
Gov. Brian Kemp [last week] declared a state of emergency for 12 Georgia counties along the state’s coastline and immediately inland from the coast. 11Alive reports that Dorian, potentially a Category 4 storm, is likely to have some impacts in metro Atlanta, mainly in the form of wind.
It can take time for the effects of the storm to be known but there are already signs that Delta could be pulling back. The short term chart below shows that the stock price is at a level that has been associated with pull backs in the past. Resistance at current levels, near $60, appears to be reasonably strong.
The longer-term chart shows that DAL has been falling after reaching all-time highs.
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.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in DAL
For DAL, we could sell a September 20 $56 call for about $2.55 and buy a September 20 $58 call for about $1.37. This trade generates a credit of $1.18, 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 $118. The credit received when the trade is opened, $118 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $382. 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 ($118).
This trade offers a potential return of about 31% 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 DAL is below $56 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 $382 for this trade in DAL.