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As vaccination efforts int the U.S. and some other countries begin to lower contagion rates in some regions, shares of travel and leisure businesses, including airlines, have started to recover from their pandemic lows. As well, expectations are for a surge in summer travel and related bookings.
Therefore, today we'll look at Texas-based American Airlines (NASDAQ:AAL), whose shares are up 38.1% year-to-date after losing 45% of value in 2020. In mid-March, AAL stock hit a 52-week high of $26.09 and is now hovering at $21.7.
Similarly, the Dow Jones Travel & Tourism index and the Dow Jones Airlines index are up more than 15.8% and 27.3% YTD respectively. Since the start of 2021, shares of Delta Air Lines (NYSE:DAL) and United Airlines (NASDAQ:UAL) and the widely-followed exchange-traded fund (ETF) U.S. Global Jets ETF (NYSE:JETS) have returned around 15.4%, 24.1% and 17.2%, respectively.
On April 22, American Airlines released Q1 results. Following the report, investors have been hitting the “buy” button—shares are up about 15% since then. Now, many wonder what might be next for the stock. Will prices go higher or will there be short-term profit-taking?
Over the past several weeks, we have discussed how investors could consider writing covered calls on their stock holdings, especially equities that have recently gone up in price. Today, we look at American Airlines and provide an example for a covered call.
Such an option strategy could help decrease the volatility of their position and offer shareholders some protection against potential declines in the stock's price. Readers who are new to options might want to revisit the initial article in the series before reading this post.
Legacy carrier American Airlines operates hubs in Charlotte, Chicago, Dallas/Fort Worth, Los Angeles, Miami, New York, Philadelphia, Phoenix and Washington, D.C. It is also a founding member of the Oneworld Alliance.
The global spread of COVID-19 has caused a severe decline in demand for air travel, which has adversely impacted the company’s Q1 metrics. Revenue was $4.0 billion, a 53% year-over-year decline. Net loss of $2.74 billion translated into a $ 4.32 loss per share. The company ended the first quarter with $17.3 billion in total available liquidity.
During the pandemic, like other carriers, American Airlines has loaded up the balance sheet with significant debt. The Street was pleased to learn that management is not planning to raise any more cash. The airline has incorporated more than $1.3 billion of permanent non-volume cost reductions for 2021.
CEO Doug Parker commented:
“We see signs of continued recovery in demand. We remain confident the network enhancements, customer-focused improvements and efficiency measures we’ve put into place will ensure American is well-positioned for the recovery.”
Management now forecasts that in Q2 capacity will be down 20-25% compared with Q2 2019. Similarly, Q2 revenue will likely decline by 40% YoY. The airline expects to end Q2 with $19.5 billion in liquidity.
Given the significant increase in the AAL share price in recent months and since the release of Q1 results, a covered call might be an appropriate strategy for some investors who want to protect at least a portion of their gains.
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.
On Tuesday, AAL stock was trading at $21.67 intraday. Therefore, for this post, we'll use this price.
A stock option contract on AAL (or any other stock) is the option to buy (or sell) 100 shares.
Investors who believe there could be 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, $21.67) is above the strike price ($20.00).
So, the investor would buy (or already own) 100 shares of AAL stock at $21.67 and, at the same time, sell an AAL June 18, 2021, 20.00-strike call option. This option is currently offered at a price (or premium) of $2.52.
An option buyer would have to pay $2.52 X 100 (or $252) in premium to the option seller. This call option will stop trading on Friday, June 18, 2021.
This premium amount belongs to the option writer (seller) no matter what happens in the future, for example, on the day of expiry.
The 20.00-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.
Assuming a trader would now enter this covered call trade at $21.67, at expiration, the maximum return would be $85,00, i.e., ($252 - (($21.67 - $20.00) X 100)), excluding trading commissions and costs.
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 AAL call option's intrinsic value is ($21.67 - $20.00) X 100, or $167.
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 $85, i.e., ($252 - $167). Extrinsic value is also known as time value.
The trader realizes this gain of $85 as long as the price of AAL stock at expiration remains above the call option's strike price (i.e., $20.00).
On expiration day, if the stock closes below the strike price, the option would not get exercised, but would instead expire worthless. Then, the stock owner with the covered call position gets to keep the stock and the money (premium) s/he was paid for selling the option.
At expiration, this trade would break even at an AAL stock price of $19.15, excluding trading commissions and costs.
Another way to think of this break-even price is to subtract the call option premium ($2.52) from the underlying AAL stock price when we initiated the covered call (i.e. $21.67).
On June 18, if AAL stock closes below $19.15, 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 AAL Stock Reaches A New 52-Week High?
As we have noted in earlier articles, such a covered call would limit the upside profit potential. The risk of not participating in AAL stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profiles, others might find that acceptable in exchange for the premium received.
For example, if AAL stock were to reach a new high for 2021 and close at $40 on June 18, the trader's maximum return would still be $85. 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 $20.00 call before expiry on June 18.
Depending on her/his views and objectives regarding the underlying AAL stock, s/he could consider initiating another covered call position. In other words, the trader could possibly roll out to a July 16 expiry call with an appropriate strike.
Bottom Line
More than half of U.S. adults have had at least one dose of a COVID-19 vaccine. Therefore, we can expect further recovery in air travel, especially in the summer months. But Wall Street is forward looking. Most of the expected positive news is likely to have been factored into share prices of airlines, including AAL stock.
The exact market-timing of when AAL 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 drops in price, especially around the earnings release date.
We regard covered call options as a potential way to earn additional income from your stock portfolio. Such a strategy also helps lower portfolio volatility. Interested investors might consider increasing their knowledge base.
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