Coming into this earnings report Southwest Airlines Co (NYSE:LUV) was up 60% in 12 months. Yet investors were obsessed with the recent -8% negative trend.
So even though LUV stock is up so much in a year and that the transport sector is within 2% of the all-time highs, trader sentiment was bad. Historically, the airline stocks don’t have a good reputation, so they are hesitant to trust them too much. The recent dip offers put sales opportunity in LUV.
Today’s negative reaction changes nothing in the overall prospects of LUV stock. The company continues to be among the best in its industry, so it commands a small premium there. But this is not to say that its overvalued. It runs a 17 trailing price-earnings ratio, which is pretty reasonable in the sector overall and in absolute terms versus the S&P 500 Index.
Technically, the long term trend in Southwest Airlines stock is consistently bullish quintupling in five years. That’s twice better than UAL, 25% better than DAL and more than five times better than the iShares Dow Jones Transport. Avg. (ETF) (NYSEARCA:IYT).
The shorter-term trend mirrors that of the weekly chart. The recent slide that started July 7 breached a 10-month ascending trend line, but is still inside of the regression channel. So if we assume that the thesis is still intact from what management delivered today, we can expect that prices will rebound to revert to the mean. Therein lies my opportunity.
Behind a predictable channel, I can sell downside risk for income. In this case, I sell mid-term puts below support and against what others fear. Then I let time do the rest.
Click to Enlarge As long as the macro-economics don’t change for the U.S. equity markets, LUV should hold above my risk so that it expires worthless in my favor. Then I keep the entire premium as profits.
I am not required to hold the trades open through expiration. I can close them for partial gains or losses at any time.
The Bet: Sell LUV stock Dec $45 naked puts and collect 80 cents to open. Here I have an 85% theoretical chance of success. But if price falls below my strike then I must own the shares and accrue losses below $44.20.
Since I left a 19% buffer between my risk and current prices, I am confident that the worst case scenario will not be a disaster. Still and even with this much room for error, not every trader is willing to take on naked premium risk. For those I can sell spreads instead.
The Alternate Bet: Sell the LUV stock Dec $45/$40 credit put spread. Here my risk is limited since I buy as many puts lower than the ones I sell. I still have the same odds of winning and earn a 10% yield on my risk.
As safe as this strategy may seem, there are no guarantees in investing. So I never risk more than I can afford to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.