Does anyone use old guard travel agencies anymore? Well, of course they do, but with the growth and ease of access to Online Travel Agents (OTA) through mobile devices the old guard travel agency business model has drastically declined. The increase of easy to use internet travel reservation apps has been a booming industry and major players have evolved. The largest of these is Priceline (NASDAQ:PCLN), but the market is shared by competitors such as Expedia (NASDAQ:EXPE), Orbitz Worldwide (NYSE:OWW) and TripAdvisor (NASDAQ:TRIP) to name a few.
You may have also heard of a company called Kayak (formerly KYAK) which was recently bought out by Priceline. With this acquisition, Priceline essentially cements itself as the leader in the OTA industry.
Last week Priceline named its price for Kayak at $1.8 billion. This broke down to $40.00 per share for Kayak (roughly $1.3 billion) plus $500 million in cash. The per share offer was a 29% increase above Kayak's previous close of $31.04 (Thursday, November 8th). This deal may pose problems for Orbitz Worldwide as a good portion of their internet traffic is driven by Kayak. It is believed that Kayak will still run independently, which may cause an issue down the road as Priceline's competitors may not wish to continue advertising on Kayak once the deal has been closed.
Here are some basic numbers for the industry:
|EXPE $57.59||20.88%||7,767||0.96||~ 1.0%|
|OWW $ 2.20||31.58%||231||0.90||N/A|
The major players in the industry have all shown a strong double digit % Earnings Per Share Growth. Expedia is the only company to offer a dividend and has a similar earnings growth to Priceline. Orbitz Worldwide has the highest earnings per share growth but it also has the lowest market cap. It is also important to note that in early November, Orbitz Worldwide beat earnings expectations but cut their full year forecast due to slower growth in the European markets.
The outlook for PCLN is predominantly bullish, but at a high stock price of over $630.00 many investors may find it difficult to procure 100 block shares of stock to trade as a married put (long term insured growth), collar (shorter term income with insurance) or covered call (shorter term income with open downside risk). Buying long term in-the-money or out-of-the-money call options for speculative growth on PCLN will cost as much as buying shares of Expedia or TripAdvisor.
Leveraged spread position:
Many of our articles focus on using protective stock positions (married puts and collars) in order to limit our risks to single digit percentages, even in the worst case scenarios. Vertical options spreads, such as a bull put credit spread, carry leveraged risk but can be very profitable trades on high priced securities.
A bull put credit spread consists of selling a put option with a strike below the current stock price (out-of-the-money) and buying a put option at a lower strike price. A net credit is achieved as the sold put option will have a higher premium than the put option you are buying. Whenever one enters into an options trade or spread position, we must understand the obligations and rights of the position:
Selling a put option: Investor may be obligated to buy shares of stock at the put strike price if the stock is trading below the strike price at or before expiration.
Buying a put option: Investor has the right, but not the obligation, to force someone to buy shares of stock if the underlying is trading below the put strike price at or before expiration.
If an investor simply sold a put (naked put position) on Priceline they would collect a premium but may be forced to buy shares of stock at a high price. The investor may also be required to put up the full amount necessary to purchase stock at the put strike price (margin requirement) for the duration of the trade.
Naked put / cash secured put example:
Sell 1 DEC 600 strike put@-$11.10 ($1,100.00 per 1 contract)
Cash secured requirement = $600.00 ($60,000 required for 1 contract)
% Naked yield = 1.9% ($1,100 / $60,000 required)
Maximum at Risk = $589.90 ($58,990 if stock drops to $0.00)
The cash secured naked trade will generate a premium but will require a large amount of capital to cover the obligations of the put option that was sold. As the profit and loss graph shows, this trade also carries a large monetary risk if Priceline has a significant decline in price. That is not our expectation, but we cannot control the market.
To alleviate the potential monetary risks, limit the monetary requirement in the trade and still take advantage of our bullish expectations we can create a bull put credit spread by purchasing a deeper out-of-the-money put option:
Bull put credit spread for Priceline :
Sell 1 DEC 600 strike put @-$11.10 (-$1,100.00 per 1 contract)
Buy 1 DEC 595 strike put @ $10.20 ( $1,020.00 per 1 contract)
Initial net credit = -$ 0.90 ( $ 90.00 for 1 contract spread)
Maximum risk / margin requirement = $ 4.10 ( $410.00 for 1 contract)
Percent maximum return = 22% ($0.90 max. gain / $4.10 requirement)
(click to enlarge)
By entering the spread position we greatly reduce the initial premium received, but we also drastically lower the monetary requirement for the position. We must point out that many discount online options brokers will only require investors to have the maximum risk ($4.10, or $410.00 per 1 contract spread) on hold in their account to place this position. Other brokers may require you to have the full spread difference or monetary requirement ($5.00, or $500.00 per 1 contract spread) on hold in the account to place the trade.
Risks and potential outcomes:
As mentioned, this is a leveraged position. The risk-reward ratio for this spread is roughly 4:1 - we are risking $4.10 for the potential to make $0.90. This is a common risk-reward ratio for vertical spread positions. In the bull put credit spread we selected an out-of-the-money put option that had a 70% or higher theoretical probability of expiring worthless at DEC expiration. We could receive a higher net credit and a lower risk-reward ratio by selling a higher strike put and buying a put one strike below it, but then our expectancy of full profit would be reduced.
If you are only trading spread positions in your portfolio you have to be careful of this risk-reward ratio. Let's say we opened four spreads that had a similar risk-reward profile. If we generated $0.90 per spread we would take in $3.60 of premium for our four trades. Each spread would have a risk of $4.10. If three of our spreads were successful for full profit, but the fourth went against our expectations for the full loss, we would come out of the month with a loss of -$0.50 (-$50.00 per contract). We would have been right 75% of the time and still lost money. This is the true danger of leveraged spread positions.
Let's review the possible outcomes for the PCLN bull put credit spread:
PCLN remains above $600.00 per share at DEC expiration
Great! Both puts would expire worthless and we would keep the net credit.
PCLN is trading between $600.00 and $595.00 per share at DEC expiration
If we did not act or adjust the position prior to expiration and the stock was between our strike prices, the 595 strike put would expire worthless and we would have to buy to close the 600 strike put to avoid assignment. If the stock was trading at $597.00 per share we would have to pay $3.00 per contract to cancel our obligation of the short 600 strike put. We would incur a loss, but it would not be the full loss for the position.
PCLN is trading below $595.00 per share at DEC expiration
Again, if we did not adjust or roll the position prior to expiration we would realize the full loss on the spread. Over expiration weekend our broker would fulfill our obligation to buy shares of stock at $600.00, then immediately exercise our right to sell to close the shares at $595.00. We would lose the $5.00 difference in strike prices but retain the initial $0.90 premium, resulting in the maximum loss of -$4.10 per contract.
Regarding point #3, your broker may handle the assignment and obligation of the spread in a different manner. Before entering any vertical spread you would want to check with your broker to see how they would handle the requirements and obligations of a spread assignment.
Lastly, we used the example of a 1 contract spread to keep the math simple. As this is a leveraged trade, you may be able to afford to trade more contracts due to the lower monetary requirement. However, as leverage can work against you just as quickly as it can work for you, it is important to keep your at risk amount on a spread position to a small percentage of your portfolio. A good rule of thumb is to keep the full monetary at risk amount of a leveraged spread position to only single digit percentages of your total portfolio value. If the spread does go against you for the full loss you have only risked a small portion of your total portfolio value.
Options spreads do involve risk and may not be suitable for every investor. Make sure you have read the Characteristics and Risks of Standardized Options (ODD). In our next article we will discuss the importance of analyzing the parity trade of a vertical spread position before entering a trade, and what management techniques may be used and should be planned for before entering into a vertical spread position.