Travel and leisure sectors have seen increased returns in recent months. For instance, the Dow Jones Travel & Leisure index is up about 8.6% year-to-date (YTD). Similarly, since the start of the year, the Dow Jones Travel & Tourism and the Dow Jones Airlines indices have returned 9.7% and 24.10%.
Cruise lines have also benefited from this recent up trend in one of 2020's most beaten down sectors. YTD, shares of large cruise operators Carnival (NYSE:CCL) (LON:CCL), Norwegian Cruise Line (NYSE:NCLH) and Royal Caribbean Cruises (NYSE:RCL) are up 21.4%, 17.3% and 22.4%, respectively.
Similarly, specialty cruise liner Lindblad Expeditions (NASDAQ:LIND), which focuses on expedition cruising and adventure travel, has also returned 16.8% YTD. Market participants now wonder whether this bullish sentiment could continue or whether a pullback in price could be in the cards.
We recently discussed how investors could consider writing covered calls on their stock holdings. Readers who are new to options might want to revisit that article before reading this post.
Today, we’ll review how a covered call could help protect some of the recent gains in Carnival stock if the market rally were to pause in the coming weeks.
Carnival
- Intraday Price: $26.62
- 52-Week Range: $7.80 - $33.34
- 1-Year Price Change: Down about 21%
Carnival is listed both in the U.S. and the UK. In fact, until June 2020, it was the only global company to be included in both the S&P 500 index in the U.S. and the FTSE 100 index in the UK. However, last year, the company was demoted from the FTSE 100 to the FTSE 250 index.
In March 2020, Carnival prided itself on being the largest cruise operator in the world. The group owns a variety of major cruise brands, including P&O Cruises, Princess, Cunard, Costa and Holland America. The post-coronavirus world, however, in March 2021 looks rather different for Carnival and its peers.
According to the company’s preliminary Q4 metrics, net loss was $1.8 billion, compared with a net profit of $427 million in the fourth quarter of 2019. Cash and equivalents totalled $9.5 billion at the end of the quarter.
Currently, management is unable to predict when the entire fleet will return to normal operations and, as a result, is also unable to provide an earnings forecast. However, the company expects a net loss on both a U.S. GAAP and adjusted basis for the first quarter and full year ending Nov. 30, 2021. The company's monthly average cash burn rate in Q4 was $500 million. It expects the rate in Q1 2021 to be approximately $600 million.
Given the recent run-up in the CCL share price, a covered call might be an appropriate strategy for some investors who believe the stock is unlikely to move up much more in the coming weeks.
Covered Calls On CCL Stock
For every 100 shares held, the strategy requires the trader to sell one call option with an expiration date at some time in the future.
Intraday Tuesday, CCL stock was trading at $26.62, though it closed a bit higher. However, for the purposes of this article, we'll use the price in affect during the time it was written.
A stock option contract on CCL (or any other stock) is the option to buy (or sell) 100 shares.
Investors who believe there could be further short-term profit-taking soon might use a slightly in-the-money (ITM) covered call. A call option is ITM if the market price (here, $26.62) is above the strike price.
So the investor would buy (or already own) 100 shares of CCL stock at $26.62 and, at the same time, sell a CCL Apr. 16, 2021, $25-strike call option. This option is currently offered at a price (or premium) of $3.85.
An option buyer would have to pay $3.85 X 100 (or $385) in premium to the option seller. This call option will stop trading on Friday, Apr. 16, 2021.
The 25-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.
Assuming a trader would enter this covered call trade at $26.62, at expiration, the maximum return would be $223, i.e., ($3.85 - ($26.62 - $25.00)) X 100, excluding trading commissions and costs.
Risk/Reward Profile For Unmonitored Covered Call
An ITM covered call's maximum profit is equal to the extrinsic value of the short call option.
The intrinsic value would be the tangible value of the option if it were exercised now. Thus, our CCL call option's intrinsic value is ($26.62 - $25.00) X 100, or $162.
The extrinsic value is the difference between the market price of an option (or the premium) and its intrinsic price. In this case, the extrinsic value would be $223, i.e., ($385 - $162). Extrinsic value is also known as time value.
The trader realizes this gain of $223 as long as the price of CCL stock at expiry remains above the strike price of the call option (i.e., $25.00).
At expiration, this trade would break even at a CCL stock price of $22.77 (i.e., $25.00 - $2.23), excluding trading commissions and costs.
Another way to think of this break-even price is to subtract the call option premium ($3.85) from the underlying CCL stock price when we initiated the covered call (i.e.: $26.62).
On April 16, if CCL stock closes below $22.77, the trade would start losing money within this covered call setup. Therefore, by selling the covered call, the investor has some protection against a potential loss in the case of a decline in the underlying shares. In theory, a stock's price could drop to $0.
What If Carnival Stock Reaches A New All-Time High?
As we have noted in earlier articles, such a covered call would limit the upside profit potential. The risk of not participating in CCL stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profile, others might find that acceptable in exchange for the premium received.
For example, if CCL stock were to reach a new high for 2021 and close at $35 on April 16, the trader's maximum return would still be $223. In such a case, the option would be deep ITM and would likely be exercised. There might also be brokerage fees if the stock is called away.
As part of the exit strategy, the trader might also consider rolling this deep ITM call option. In that case, the trader would buy back the $25 call before expiry on Apr. 16. Depending on her/his views and objectives regarding the underlying CCL stock, s/he could consider initiating another covered call position. In other words, the trader could possibly roll out to a May 21 expiry call with an appropriate strike.
Bottom Line
The exact market-timing of when CCL shares could take a breather is difficult to determine, even for professional traders. But options strategies provide tools that might prepare for sideways moves or even falls in price in stocks.