Xerox Could Be a Double-Digit Income Stock
Trade summary: A bear call spread in Xerox Holdings Corporation (NYSE: XRX) using September $14 call options for about $2.40 and buy a September $18 call for about $0.58. This trade generates a credit of $1.82, 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 $218. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($182). This trade offers a potential return of about 83% of the amount risked.
Now, let’s look at the details.
Like many large companies, XRX is experiencing challenges. Barron’s reported, “Earlier in the year, the company’s bold bid to buy HP Inc. flopped. And then the Covid-19 pandemic crushed the company’s business.
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Xerox stock is the opposite of a work-from-home play–people do not need high-end office printers and associated supplies when they’re not in an office.
J.P. Morgan analyst Paul Coster cautions [recently] that a near-term rebound for the stock is not in the cards. He cut his rating on the stock to Underweight from Neutral, with a new price target of $20, down from $23.
XRX reports second-quarter results [soon], and Coster notes that expectations are low given Covid-related headwinds “as the shift to work from home weighed on variable usage and new equipment sales.”
He actually thinks trends will get better toward year end, and adds that management could get more aggressive on cost cutting to boost free cash flow and profitability.
Coster thinks the stock is statistically cheap, with a forward price-to-earnings ratio of seven times. But he says that secular decline in enterprise printing, the Covid-19 disruption, and strategic uncertainty “makes it a difficult equity story to own right now.” Seeing no catalysts, he says it’s time to abandon ship.
“These are trough level multiples, a discount to the peer group, implying that the stock is currently undervalued,” he writes. “That said, the firm faces secular challenges, disruption from COVID-19 and its ability to execute M&A seems constrained for now, so the equity story lacks catalysts.”
For the June quarter, he projects revenue of $1.54 billion–down 32% year over year–and a pro forma loss of 6 cents a share. The company previously withdrew guidance in the face of Covid-related uncertainty.
XRX has been in a relatively narrow trading range and failed to participate in the rally that began in March for the broader stock market.
The current range violates support on the longer-term chart using weekly data that is shown below. That support is now resistance that could limit the upside potential of the stock.
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 XRX
For XRX, we could sell a September $14 call for about $2.40 and buy a September $18 call for about $0.58. This trade generates a credit of $1.82, 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 $182. The credit received when the trade is opened, $182 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $218. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($182).
This trade offers a potential return of about 83% 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 XRX is below $14 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 $218 for this trade in XRX.
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.