Gap (NYSE:GPS) shares have gained more than 40% year-to-date, and option traders are expecting this upside to continue for the next several weeks. The apparel retailer’s options pits were active yesterday as a large bull call spread traded in the May series.
The May 28 call and May 30 call both saw 6,700 contracts change hands. This volume translated as new open interest today as the positions were on the opening side. It appears as though traders bought the May 28-strike call and simultaneously sold the May 30-strike call. They paid 58 cents for the lower strike and collected a 17-cent premium for the higher strike, making the overall debit 41 cents for this bull call spread.
If GPS is trading at or above $30 when these options expire, profit is maximized at $1.59, which is the difference in strike prices less the total debit paid for the spread. The maximum potential loss — if GPS is trading below $28 when the options expire — is the 41-cent debit paid. That’s a nearly 400% potential return on risk (the ratio of the potential reward of $1.59 versus the potential risk of 41 cents).
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Breakeven for this spread is $28.41 at expiration. GPS needs to be trading above this level when the options expire for the trade to be profitable.
What’s notable about this trade is that it uses a traditionally conservative strategy in an aggressive way. If all goes according to the trader’s plan, GPS will have moved above 30 by expiration on May 18. That’s a jump of more than 13% in just about six weeks.
By trading this bullish hunch with a call spread instead of a straight long call, however, the premium is reduced by the amount collected for selling the higher-strike call. The tradeoff is that upside is capped at the 30 strike, so if GPS were to rally past this level, the long call would have been the better play.
Also interesting is the fact that Gap is currently scheduled to report earnings on May 17, one day before these options expire. Analysts are expecting the retailer to earn 35 cents per share, which is a nickel below year-ago results. GPS has topped the consensus estimates in seven of the last eight quarters.
Yesterday, the stock moved higher after Caris & Co. lifted its rating on the shares to “above average” from “average” and raised its 12-month price target by 18%, to $32. This represents roughly 20% of upside from the stock’s current price.
In early trading today, the stock is down one quarter of one percent.
As of this writing, Beth Gaston Moon does not own any shares mentioned here.