Shares of American Airlines (NASDAQ:AAL) have taken off into the stratosphere over the past week. And AAL stock has nearly doubled so far this month as the lockdowns loosen and businesses reopen.
Certainly, the fear of bankruptcy helped crash American Airlines and its peers to overly pessimistic levels. Now, in a similar vein, an overly optimistic outlook is now pushing AAL stock to an unstable flight path.
What do I mean? It’s time for American Airlines to prepare for descent.
American Airlines: Valuation View
No one really knows how the airlines will emerge from the novel coronavirus. One thing that is generally agreed upon, however, is that there will undoubtedly be a detrimental effect for the foreseeable future. American Airlines itself acknowledged as much by announcing layoffs as it prepares for the termination of federal aid in the coming months.
The massive $2.65 net loss from last quarter serves to show just how deep the crisis is for the airline industry. Consensus expectations are for an even bigger loss next quarter of $7.41. Even with states reopening, many travelers will likely be reluctant to get on a plane until there is a vaccine.
It will take many months for American Airlines to come remotely close to the demand levels that were evident before the coronavirus crisis began.
My Technical Take on AAL Stock
AAL stock is very overbought from a technical standpoint. The 14-day relative strength index (RSI) is approaching 80 and is at the highest level over the past year. Moving average convergence/divergence just breached 1 and is also at 12-month highs.
Momentum is getting to an extreme — one that’s rarely been seen. Bollinger Percent B is finally weakening after getting to bearish readings. American Airlines stock is also trading at a massive premium to the 20-day moving average. That’s another sign of overexuberance. There is major overhead resistance at the $25 area.
Most importantly, AAL stock had a key reversal day Friday and an inside day Monday. This is usually a signal that the trend may be coming to an end and a period of indecision may be looming. Neither the buyers nor sellers are in control. An inside day after such a strong rally, however, can many time be a sign of exhaustion. There is a distinct probability that a counter-trend reversal may be in the offing.
What Does All the Volatility Mean?
A look at comparative volatility over the past week shows how frothy the options market has become. This is usually a reliable, contrarian indicator. It also favors option selling strategies when constructing trades.
The table below shows the option montage for AAL stock from June 3. The highlighted $16 strike price is roughly 25% out-of-the money and trading at 91.50 IV. Dividing the midpoint option premium (0.145) by the stock price equates to 1.2% of the price of the stock.
The option montage below is from June 8. The $25 strike calls are roughly 25% out-of-the money but trading at over a 150 IV. Dividing the midpoint option price (0.795) by the stock price equates to 3.9% of the price of the stock. This indicates how much more dramatically expensive the call prices have become over the course of the past week in AAL stock.
I had a decidedly bullish view in my previous research piece on AAL stock from March 11. Both the technicals and fundamentals were a screaming buy back then. Now that American Airlines has rallied nearly 50% in that time frame, my bullish outlook has turned to a more bearish tone. Price does matter.
So to position for the red-hot rally to stall — and to capture some comparatively rich option premium — a simple bear call spread makes probabilistic sense.
How to Trade American Airlines Stock
Sell the AAL June $25/$28 call spread for a 40 cents net credit
Maximum gain on the trade is $40 per spread with maximum risk of $2.60 per spread. Return on risk is 15.38%. The short $25 strike price provides a 23% upside cushion to the $20.31 closing price of AAL stock. It is also structured right at the major resistance level of $25.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a weekly option and volatility newsletter can visit the Options and Volatility Newsletter website.