By Jared Levy on October 7, 2014
Check Out Profitabletrading.com for details of the trade
Rumors of the Ebola virus in the United States are spreading like an epidemic across the news and social media. As scary as the virus is, the likelihood of an outbreak here has been grossly exaggerated, and the “Chicken Little” effect is spawning opportunities in the market.
To be clear, I’m not making light of this very serious situation. My goal is to show you how a logical, rational investor can profit from an irrational reaction by the masses.
The bravest and smartest investors look for opportunity when others are panicking. Warren Buffett is one of the greatest investors of all time, and he is also a known contrarian. During the throes of the financial crisis in 2008, he said, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
Buffett famously made a bullish bet on Goldman Sachs (NYSE: GS) in 2008, when most people wouldn’t go near a bank stock. The trade netted him $2 billion over a four-year period. This 40% return was far from his most successful trade, but it is a great example of a well thought out investment in a time of panic.
There have been more than two dozen documented Ebola outbreaks since the virus was first identified 38 years ago. The most recent outbreak is the worst we have seen, killing more than 3,400 people since March, according to the Centers for Disease Control and Prevention (CDC). But the overwhelming majority of cases are in West Africa, with one being confirmed in the United States.
Fear is running high, though, with the CDC reporting it is getting 800 calls a day regarding potential cases, none of which have been diagnosed as Ebola. The CDC said it is confident that U.S. cases will be limited and controlled, but it acknowledged the minimal potential for further infection.
As the media has fanned the flames of hysteria, there have been calls to ban all air travel from West African countries. Health officials opposed the idea, saying it would impede the efforts of aid workers.
However, not surprisingly, many investors overreacted to the news and sold airline stocks indiscriminately. American Airlines (NASDAQ: AAL), Delta Air Lines (NYSE: DAL), United Continental (NYSE: UAL), JetBlue Airways (NASDAQ: JBLU) and Southwest Airlines (NYSE:LUV) all took a hit.
I find the sell-off in Southwest particularly overdone since the only international flights the airline operates are to Mexico and the Caribbean.
While some Americans may avoid international travel, especially to infected regions, I doubt Southwest’s domestic business will see a huge impact. And while some may worry about the cost of increased screening for travelers before they are allowed into the States, the government will be footing that bill, not the airlines.
The bottom line is that this recent correction in the stock, which was partially due to a pullback in the broad market, gives us a chance to get back into Southwest at a discount.
I recommended a profitable trade in LUV in late August, based largely on lower jet fuel prices and the repeal of the Wright Amendment. This long-standing law restricted nonstop service from Love Field in Dallas, where Southwest is headquartered, to airports in Texas and eight other states. This has limited the airline’s routes, and therefore its profits, for the past 35 years.
When the law is repealed in mid-October, traffic at Love Field is expected to increase nearly 50%, and Southwest will be in a prime position to capitalize on it. The news is likely to put the stock back in a positive spotlight next month.
The company is also scheduled to report third-quarter earnings on Oct. 23, before market open, which is likely to be a positive catalyst for shares. Analysts have been steadily increasing their estimates ahead of the announcement. They now expect the company to show a quarterly profit of $0.51 per share, up from $0.44 per share 90 days ago.
As you can see in the chart below, LUV has a long history of delivering positive earnings surprises.
In the past four quarters, it has beaten analysts’ estimates by an average of 13%. Following each of these reports, the stock gained at least 10% within six weeks.
Due to general market weakness and panic selling over the Ebola virus, shares of LUV are 7% off their 52-week high, made just over two weeks ago. This presents us with a great entry point.
If the company beats estimates as I predict, a 10% move higher over the next few weeks is likely. We can use a call option strategy to lower our risk and amplify our return to 66%.
LUV Call Option Trade
Today, I am interested in buying LUV Dec 30 Calls for a limit price of $3.80. (trading $3.50)
Risk graph courtesy of tradeMONSTER.
This call option has a delta of 77, which means it will move roughly $0.77 for every dollar that LUV moves, but it costs a fraction of the price of the stock.
The trade breaks even on expiration at $33.80 ($30 strike price plus $3.80 options premium), which is 2.3% above current prices.
If the stock rises 10% like it has in the past after reporting earnings, shares would reach the $36.30 level. At this point, our call option will be worth at least $6.30. Once you enter the trade, place a good ’til cancelled (GTC) order to sell the calls at that price.
Recommended Trade Setup:
— Buy LUV Dec 30 Call at $3.80 or less (use a limit order)
— Set stop-loss at $1.30
— Set price target at $6.30 for a potential 66% gain in less than two months
If you have a question or comment about today’s strategy, please send it to[email protected].
Fox – Treasury yields decline as stocks continue to slide