Weakness is provocative.
Investors have recently begun to aggressively buy stocks battered by Covid-19 for seemingly no reason other than their prices are low at a time when market leaders are trading around 52-week highs.
It doesn’t matter, at least not much, if their earnings estimates or business prospects fail to match the enthusiasm in the stock and options markets. All that seems to matter is that stocks that have been pounded lower offer relatively inexpensive ways to potentially profit as the S&P 500 index looks poised to retest record highs.
The airline sector, for example, which was particularly hard hit by the coronavirus, is now exhibiting extraordinary price action. The U.S. Global Jets exchange-traded fund (ticker: JETS), comprised of major airline stocks, is up about 45% since mid-May. The ETF fell some 60% from mid-February to mid-March.
Rather than wagering on the entire airline sector, investors appear to be more heavily focusing on single-stock trades in best-in-breed operators that can perhaps outperform the sector.
Consider Delta Air Lines (DAL). The airlineonce counted Warren Buffett among its top shareholders, though the famed investor has since sold off his airline holdings after Covid-19 hobbled the industry.
On Tuesday, in a major sign of the laggards-will-be-leaders trade thesis, Delta’s stock rose about 13%, or about six times more than the S&P 500. The airline stock’s advance suggests that Covid-19-damaged stocks and sectors may increasingly appeal to aggressive traders who are looking for extraordinary returns should life return to some semblance of normal after months of quarantine and economic shutdown.
With shares of Delta around $26, investors can buy the January $27 call option and sell the January $32 call spread for about $2.20 If the stock is at $32, they make a profit of $2.80, or 127%. During the past 52 weeks, Delta’s stock has ranged from $17.51 to $63.44.
The call spread—that is, buying a call and selling another with a higher strike price but similar expiration—is a strategy that is used to profit from trading ranges in stocks. It limits risk because the amount that can be lost is limited to the money paid to establish the spread. The profits are limited to the “spread” between the two strike prices.
The strategy has been popular among many institutional investors since the financial crisis because it is often possible to realize returns of 100% or more if everything works as planned. In a rising market, the trade is often a winner. But if the stock declines, or never rises above the cost of the spread, the trade fails.
Of course, the great overhanging risk to this budding bullishness for battered stocks remains Covid-19. Everyone seems to have their own favorite facts that they use to demonstrate why it is or isn’t safe to end the quarantine and economic shutdown.
All that we know for certain, though, is that shares of Delta are down 55% so far this year, reflecting the near shuttering of air travel that was caused by the pandemic. We know that Delta has grounded airplanes, accessed capital markets for liquidity, and suspended a stock-buyback program to preserve cash. A return to pre-Covid 19 business conditions is hard to imagine, but Delta recently said that it is planning to add more flights to its June schedule, which happens to coincide with the gradual reopening of the U.S. economy.
Investors are bullishly testing the thesis in the options market. One recently bought 4,000 Delta January $40 calls and sold 6,000 January $50 calls for 57 cents. The “ratio spread”—named because more calls were sold than bought—positions investors to profit if the stock is above $40.57 while creating an obligation to sell stock at $50.
If the nation’s economic future is better than feared, once-loved stocks like Delta could stay on the comeback express.
Originally Posted on May 28, 2020 – Battered Delta Stock Could Take Off. Here’s How to Play It.
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