This Unloved Stock Could Deliver an 80%-Plus Short-Term Gain
While value investing and short-term trading seem to be at opposite ends of the investment spectrum, there are ways short-term traders can use long-term value investing principles to profit. Value investors look for cheap stocks and buy in the hope that over the long term there will be a very large move in the stock. When a short-term trader finds a value stock with a chart that is indicating that it’s a buy, they can trade it for a short-term gain as the value investors are accumulating their positions. And through the use of options they could leverage a relatively small price move into a large gain.
Looking at unloved sectors in the stock market, the hunting ground for many value investors, airlines stand out as dismal performers besieged by bad news. Some of the major airlines may not make it — bankruptcy seems to be part of the business plan for major carriers. Regional airlines, on the other hand, seem to have business plans based on profitable operations. Among the regional airlines, Southwest Airlines (NYSE: LUV) stands out as a potential trade.
The weekly chart shows that LUV is trading near support. The pattern could be thought of as an extended cup-and-handle with the handle currently being formed and defining the support level.
The 52-week high is slightly above $10 a share and there is every reason for a value investor to believe that the stock will eventually return to that level.
Earnings are steady and growing. The company reported earnings of 43 cents a share in 2011, and it is expected to report 65 cents a share this year and 96 cents in 2013. Based on next year’s expected earnings, LUV is trading at a price-to-earnings (P/E) ratio of less than 10, which is less than a third of the five-year average P/E ratio of 35.
LUV is also trading below its book value and has enough cash on its books to pay off all the company’s debt obligations. These are additional factors that value investors like to see.
LUV is scheduled to report earnings for this quarter in mid-October. The company has beaten analysts’ expectations in each of the past four quarters, and if it beats expectations again, the stock price could move higher. This is the type of company that could make a great options trade since there is probably already buyers interested in the stock and we have an event (the earnings release) that could be a catalyst to move the stock price.
In looking at LUV options, there is not much of a difference in the price of options expiring in December compared with those expiring in October or November. For about 15 cents more, we can add 60 days to the option‘s life and increase our chances of success with this trade. December $8 call options on LUV are trading at about $1.10, which is the ask price. Traders can use a limit order to enter the trade and should be able to buy at a slightly lower price.
With LUV currently trading at $8.86, the option trade will be profitable if the stock increases by 24 cents. The chart pattern shows that a target of $10 is possible. The option would be worth at least $2 if LUV trades at $10, offering a gain of more than 80% for those who buy the option at $1.10 or below.
Value stocks can offer trading opportunities for those willing to take positions ahead of an earnings report that may confirm the buy decision of long-term investors. LUV is an example of this kind of trade and the profit potential is significant relative to the low price of the options.
Action to Take –> Buy LUV Dec 8 Calls at $1.33 or less. Do not use a stop-loss. Set initial price target at $2 for a potential 50%-plus gain by expiration.