By: Costas Bocelli — October 30, 2019
Then, five months later in March, an Ethiopian Airlines 737 Max crashed killing all 157 passengers.
After the second crash, all 737 Max aircraft have been grounded worldwide.
What’s Wrong With the Max?
At issue is the flight-control system known as Maneuvering Characteristics Augmentation System (MCAS).
Boeing (BA) has been working around the clock in developing software fixes and additional safety protocols to ensure that this can never happen again.
But regulators have yet to sign off on them.
The grounding, now going into its eighth month, is having a direct impact on Boeing’s top and bottom line.
The company reported third quarter earnings of just $1.45 per share, which was $0.67 below consensus forecast.
Sales declined by 20.5% to $19.95 billion from the same quarter a year ago.
Getting the 737 Max certified and back in the air is of utmost importance for Boeing.
Over the next five years, the 737 Max is projected to account for 33% of Boeing’s total Sales revenue.
In the conference call with analysts discussing third quarter results, Boeing said: “We have developed software and training updates for the 737 Max and continue to work with the Federal Aviation Administration and global civil aviation authorities to complete remaining steps toward certification and readiness for return to service.”
Positives for Boeing
The company continues to remain optimistic that regulatory approval of the 737 Max’s return to service will happen by the end of this year.
Boeing also plans to ramp up the production rate of the 737 Max from 42 per month to 57 per month by late-2020. The current backlog includes more than 4,600 orders for the 737 Max.
Negatives for Boeing
There’s plenty of uncertainty for Boeing shareholders.
The public backlash and supposed mistakes in developing its troubled 737 Max is a significant concern. Earlier this week, Boeing CEO Dennis Muilenburg was blasted by both houses of Congress in publicized hearings over the handling of the 737 Max. Many of the legislators are calling for him and the entire board to step down.
Then there’s the liability uncertainty.
Should the 737 Max get regulatory approval and things begin to normalize, how much monetary exposure will the company ultimately be on the hook for?
The grounding has cost Southwest Airlines (LUV) $435 million in operating income since March, when regulators took the Max out of service following the second fatal crash.
American Airlines (AAL) estimated that its full-year Max-related loss will be $540 million.
American Chairman and CEO Doug Parker, whose airline canceled 9,475 flights in the third-quarter because of the grounding, said he is in early talks over compensation. “We feel highly confident that the losses that American Airlines has incurred won’t be incurred by American shareholders, but will be borne by the Boeing shareholders", Parker said on an analysts call.
And that’s just a couple of Boeing’s domestic customers.
For sure, the stock has been punished since the grounding.
BA is down more than 20% from its all-time high of $440 per share on March 1st, days before the second fatal crash.
(Click any image to enlarge)
The bullish case is that most of the bad news is priced into the stock.
The bearish case sees the stock technically broken and will eventually take out the winter correction lows around $290 per share.
For owners that see the glass half full and think that the 737 Max will get that FAA approval by the end of the year, it makes sense to not only hold onto the shares, but use the selloff as an opportunity to add to the position.
If that happens, the stock will surely pop and the supersized position will recoup the lost ground far quicker, right?
But what if things happen to go from bad to worse?
Doubling down on a losing position may prove to be a painful and costly decision, wouldn’t you say?
So for me, adding more exposure in the face of so much uncertainty would feel too risky.
The good news is that there is an options strategy that can have us add more bullish exposure without adding more risk.
And the best part…
…If you construct the position properly, it won’t cost you a penny.
How To Double Down In BA Without Adding Any More Risk
To add more upside leverage (aka, doubling down on an existing stock position) without adding more risk, we’re going to construct a Ratio Vertical Call Spread.
Don’t let the complicated name fool you. The strategy is quite simple and easy to learn.
It’s designed to give your stock position added upside potential, like a jet engine.
And like I said, it does not add any additional downside risk other than what you already have on your existing stock position!
When used in conjunction with a long stock position, the ratio vertical spread simply entails buying ONE slightly out-of-the-money Call and selling TWO higher strike out-of-the-money Calls against it.
You’ll want to do this in the same expiration date (preferably 3-6 months out) while maintaining the proper ratio. The proper ratio is: For every 100 shares of long stock you wish to double down, you'll buy one Call option at the lower strike, and sell two Call options at the higher strike.
That essentially leaves you with a bull call vertical spread, plus an added higher-strike call contract which you've sold. Even though you’re short that extra call contract, you’re still completely covered by the long stock position, so you’re truly hedged.
In the case of BA, for every 100 shares of stock held, you could look to buy one March 360 Call and sell two March 390 Calls to create the ratio vertical spread. With the stock recently trading around $345 per share, you’ll find that the trade sets up for EVEN, meaning there is no cost to put on the options trade.
What this essentially does is give you additional upside potential (although limited) without having to pay for it, because you finance the vertical spread cost by selling that extra Call option contract. At the current prices, it sets up for EVEN money.
The idea is that if the stock does indeed recover and trade higher, the option structure will act like a double stock position in between the two option strikes, magnifying your gains.
If this result materializes, you’ll find that your double down strategy has made up a great deal for the lost ground from those previous highs, needing only a smaller rise in the underlying stock price.
Ideally, you’ll want the stock to trade above the short call strike, which is your maximum profit gain and likely your position exit. At that point, not only have you picked up all the gains from the long stock position, but you’ll pick up the difference between the two option strikes for an additional gain.
If the stock does not rally back up... well, then you’re essentially in the same position as when you put on the trade. However, you'll have incurred no additional losses from the option trade because you’ll have laid out nothing to buy the 1x2 ratio spread.
You will face an opportunity cost. Should the stock really take off and soar even higher, beyond the higher strike where you sold the Calls, your gains will be capped at that point and your stock position will be called away.
But hey, remember: The double down strategy offers no additional risk and costs you nothing. So the downside is the unlimited upside potential, aka, opportunity cost.
BA is trading $345 and the position is full of uncertainty. Come March, exiting at an equivalent of $420 per share seems like a great result, wouldn’t you say?
Want to learn more about options and how they can make you a better investor? Then you’ll want to check out Options Soup, our options education program.
Give us a call at 855-822-0269 or click here now to learn more.
Until next time,