It's a new year, and analysts are adjusting their opinions on stocks and sectors. This week, Goldman Sachs (NYSE:GS) expressed a bit of optimism on the newly resuscitated General Motors (NYSE:GM), initiating coverage on the stock with a "buy" rating.
The covering analyst set a 12-month price target of $43, representing about 16% of upside from current levels. He noted, "GM is ideally positioned to take advantage of the cyclical … and secular auto demand opportunities" and added, "we think the stage is set for profitability not seen since the 1970s, which is not fully discounted in the shares."
December 28 was the first day banks involved in GM's IPO were allowed to rate the shares. That day, four firms issued reports on the automaker, two of which gave "outperform" ratings and two of which rated the stock an "overweight." Price targets for the upcoming 12 months ranged from $42 to $50.
Investors interested in the bullish angle on GM may be looking for an alternative to buying the stock outright, and there are a variety of options strategies that take a bullish stance but have a different risk and/or reward profile to the long stock. Similarly, those who want to hedge against the bullish current may want an alternative to shorting the stock (which can be a risky venture).
Two option strategies are outlined below – a diagonal call spread for the bulls and a long put spread for the bears. These descriptions are for educational purposes and are not buy/hold/sell recommendations. Prices were taken on Tuesday afternoon, when GM was trading at $37.19, up 13 cents on the day.
Bullish Option Strategy: Diagonal Call Spread
A diagonal call spread – combining elements of a time spread and a vertical spread – might be one option-trading alternative for GM bulls. For example, a trader could buy January 2012 30-strike LEAPS calls for $10.00 and simultaneously sell the shorter-term March 39-strike calls for $1.30 each. Essentially, shorting the March option helps offset some of the cost of the LEAPS call. The long-term purchased call is a proxy for the long stock and the short call essentially creates a synthetic "covered call" position.
If the traders remain bullish in GM through March expiration but the 39-strike calls remain out-of-the-money and expire worthless, the trader could sell another shorter-dated call, perhaps with a June 2011 expiry, to further offset the purchase price of the original LEAPS call. If GM shares are higher than $39 (and therefore in-the-money) as the first expiration date approaches, the trader could opt to roll these calls up and out to a later month (again, perhaps June), collecting additional credit to once more offset the initial cost of the 30-strike LEAPS.
If the investor chooses not to roll the short call, maximum loss at March expiration is limited to $8.70, or the difference in premiums. However at the first expiration, the long January 2012 option will have 10 months remaining until expiration and will very likely have substantial time value left.
This process requires active monitoring as the March option is intended to be covered at a later date. Spreads such as these can ultimately mean exposure to a longer-dated long call for a reduced premium price. For the long call, gains are theoretically unlimited and losses are capped at 100% of the premium paid (less any credit collected from selling short calls). Note the caveat that the declaration of a dividend could have a negative impact on the theoretical value of the LEAPS call.
It may be beneficial for you to experiment with how changes in stock value, implied volatility, and time until expiration could impact the value of this strategy. I would recommend using a profit/loss calculator such as the one available as part of an OptionsHouse virtual options trading account.
Bearish Option Strategy: Bear Put Spread
General Motors bears could consider a long put spread, by shorting the March 35 put and simultaneously buying the March 37 put, paying a net debit of 90 cents. At expiration, the most this spread can lose is the 90 cents paid (should GM be trading above the 37 strike).
If GM is trading below 35, the maximum potential profit is $1.10, or the difference in strikes less the debit. Return on risk for this play is 122%. Breakeven (at expiration) is $36.10, or the long strike less the debit paid. If GM is trading anywhere below this level, the spread will be profitable as the options expire. This is a drop of nearly 3% from the stock's current levels.
Please refer to Characteristics and Risks of Standardized Options, copies of which can also be obtained by contacting our Customer Service Department at firstname.lastname@example.org.