Headlines often cause too much harm to stocks of quality companies. These are long entry opportunities. Southwest Airlines Co (NYSE:LUV) is one such, so I want to go long LUV stock.
Traders had it wrong when they recently sold the airlines lower on the storm headlines. I say this not because they are not going to suffer financial consequences from the disruptions, but because stocks like Southwest are already undervalued, so there wasn’t that much to sell, storm or not. Besides, the effects on travel most often lasts as long as the storm itself, then they are back in business.
What may have made matters worse for LUV stock is the fact that its slide had already started in July, when it fell 15% around the earnings report. After the storms, the losses extended to 20%. So a few days ago, I decided that I wanted to catch the falling knife and I bought calls in LUV.
Click to Enlarge No, I am not here today to brag about my 50%-plus profit on that trade. I am sharing the second part of my strategy. Now that I see that the LUV bulls had enough conviction to stabilize against strong negative headlines, I want to add to my longs by selling downside risk in order to generate free profits.
I don’t want to add to my calls because although the price action in Southwest stock since last week is constructive, there could be trouble ahead around $55.75. This has been pivotal and it’s dead center of the violent candle on earnings day. That giant Doji candle on July 27 tells me that there is extreme indecision around it. I don’t fear another crash in Southwest stock, but rather a potential stall.
So from here, I worry about some forward resistance. However, this doesn’t shake my resolve in the support that the bulls just established. After all Southwest just got tested hard and they were able to stabilize and immediately bounce 10%. This is value I can use to profit.
By using this strategy, it is important to note that I commit to owning shares of Southwest if support fails. LUV sells at a 17 price-to-earnings ratio and has decent net margins. And they pay a dividend to boot.
Analysts’ ratings are split between BUY and HOLD but they all agree that price is going higher. Their average price target for LUV is $67 per share which is 22% away from current levels. This could cause some of them to lower their targets. Those headlines are potentially damaging to my longs.
LUV Stock Trade Idea
The Trade: Sell Jan 2018 LUV $47 put naked and collect $1.10 per contract to open. This is bullish trade has an 80% theoretical chance of success. But if the price falls below my strike, then I own the shares and could accrue losses below $45.90.
Selling naked puts requires margin, so those who prefer finite risk can sell spreads instead.
The Alternate Trade: Sell LUV Jan 2018 $47/$45 credit put spread where I have about the same odds of winning, but with much smaller 30-cent risk at stake. Yet, the spread would deliver 15% in yield.
There are no guarantees when investing in the stock market, 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 as @racernic on twitter and stocktwits.