Is It Time for a Safe Landing in Southwest Airlines Stock?
Southwest Airlines (NYSE:LUV) investors have had steady gains since July; however, there might be some weakness in the LUV stock price in October that would require preemptive moves. Specifically, there are two mildly bearish plays in LUV that I want to share with you, as each play could lead to impressive profits.
The world’s largest low-cost carrier with an extensive U.S. network, Southwest Airlines, has not offered investors a good return during the first half of 2018. Jet fuel, which represents approximately 25% of LUV’s operating costs, is up almost 50% over the past year. This has been adding stress to the profit margins within the industry.
Furthermore, in April, an unfortunate in-flight accident killed a Southwest Airlines passenger when a fragment of a broken plane engine went through a window. Following the accident, Southwest Airlines chose to stop advertising for several weeks; passenger bookings went down considerably during the summer, which would have otherwise been a high travel season for Southwest Airlines.
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Despite the setback earlier in the year, Southwest Airlines is a well-managed company that has continuously delivered strong financial results. LUV stock also has high brand recognition and loyalty. Warren Buffett, who has not been the biggest fan of the airline sector in the past, has recently increased Berkshire Hathaway’s (NYSE:BRK.A)(NYSE:BRK.B) stake in LUV stock by 20%. Many analysts indeed believe that Buffet may buy Southwest Airlines outright soon.
After hitting a 52-week low in early June, Southwest Airlines stock has stabilized throughout the summer and gone up about 25%. The 52-week price range for the stock has been $49.93 (June 6, 2018) — $ 66.99 (Dec 21, 2017).
LUV is expected to report Q3 earnings on Oct. 25. I expect some profit taking before the Southwest Airlines Q3 earnings call. Those investors who pay attention to oscillators should note that these technical indicators are giving “overbought” readings. LUV stock has fallen three days in a row on increasing volume, another sign that short-term profit taking might be on the horizon. Short-term support for Southwest Airlines is first at $61 and then at $59.3; meanwhile, short-term resistance in LUV stock is first at $62 and then at $63.55.
If you believe that there might be some moderate short-term profit-taking in Southwest Airlines stock before its Q3 earnings call, here are the two trades set up for the stock (prices are based on Southwest Airlines stock’s closing price of $61.70 on Oct. 1):
Two Moderately Bearish Strategies on Southwest Airlines Stock
1. If you already own Southwest Airlines stock, consider using an in-the-money (ITM) covered call to protect some of your profits in the stock. For every 100 shares of LUV stock you own, sell a LUV 16 Nov $60 call option, which currently trades at $3.20. The $60 option is slightly in-the-money (ITM), offering more downside protection in case of volatility and a decline in LUV stock around the earnings call season.
This call option would stop trading on Nov. 16, 2018 and expire on Nov. 17.
Assuming you would enter this covered call trade at the closing prices on Monday, Oct. 1, at expiry the maximum return would be $150 (i.e., ($3.20 – ($61.70-$60))*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 trader realizes this gain as long as the price of LUV stock at expiry remains above the strike price of the call option (i.e., $60).
At expiry, this trade would break even at a LUV stock price of $58.5 (i.e., $60-$1.5) excluding trading commissions and costs.
2. Consider a bear put spread whereby you would purchase a LUV put option at a specific strike price, while also selling the same number of puts with the same expiration date at a lower strike price. Traders could use this strategy when they expect moderate downside in LUV stock within a given period.
Therefore, as the first leg of the bear put spread, I would consider buying a LUV 16 Nov $62.5 put option, which currently trades at 2.76. At the same time, for the second leg of the bear put spread, sell a LUV 16 Nov $57.5 put option, which currently trades at 59 cents.
These put options would stop trading on Nov. 16, 2018 and expire on Nov. 17.
Your maximum risk would be $217 (i.e., $2.76 – $0.59) * 100) at a price of $62.5 at expiry (excluding trading commissions and costs). If Southwest Airlines stock were to close above the strike price of the long put (i.e., 62.5), you would lose the entire amount invested in the spread, i.e., $217 (plus trading commissions and costs). In other words, the maximum risk is the net premium paid at the initiation of the spread.
Your maximum return would be $283 at a LUV stock price of $57.5 at expiry (excluding trading commissions and costs). In a bear put spread, your maximum profit would be equal to the difference between the two strike prices (i.e., 62.5-57.5), minus the net cost of the options (i.e., $2.17) times 100.
At expiry, this trade would breakeven at a LUV stock price of $60.33 (i.e., $57.50+2.83).
The Bottom Line on LUV Stock
I believe moderate profit taking in Southwest Airlines stock is coming. However, as prudent investors, it is always crucial to maintain a clear risk/return profile. Thus, if the drop does not happen, a test of the previous highs and further, up toward the $70’s level, could be the next leg up.
As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.
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