October 6, 2017
4 minutes read
Dollarama has been a bright spot in the Canadian markets throughout the last year. During the first half of the year, the share price has been working considerably higher off its $93.27 52-week low. Recently investors were rewarded when the company released its 2nd quarter results and subsequently announced plans to buy back its own stock which has resulted in a 10% surge to its recent highs near $140.00 a share.
The company, by all accounts, is a relative strength leader and now a good momentum play. While the company has been a sound investment for many investors, there are now an increasingly larger number of traders looking to profit from the stocks bullishness.
Option vs Stock Dilemma
Our trader is bullish the stock and continues to anticipate further strength higher over the next 45 days. Note that the trader is looking at this as a short-term advance and not a longer-term investment. The shares of Dollarama have been quite volatile and even with stop loss orders in place, there is considerable drawdown risk if the stock was to reverse its strong upward momentum. This is where a trader can debate if using a call option or a bull call spread can offer a better risk/reward proposition.
Here is the comparison using the OptionsPlay software, which is available at no cost on the Montreal Exchange website – https://www.m-x.ca/optionsplay/en.html
So, in our first and simplest scenario the investor outlays the $13,703 for every 100 shares. While the model assumes a full, undefined downside risk, we can assume that most of the risk will likely be contained within one standard deviation, or about $8.68 lower to $128.22.
So, the question our trader is looking to debate is the potential benefit of utilizing a call option as an alternative trading vehicle to the stock ownership. In this case, in the second scenario, the investor alternatively buys the November $135 call option for $4.65 a share or $465.00 a contract. This secures the trader the right, but not the obligation to buy the shares at $135 price over the next 45 days.
Finally, the 3rd option would be to further reduce the breakeven and capital outlay by opening the trade as a debit spread. In this case, we have a November $135/$145 vertical bull call spread for a $3.80 per share or $380.00 cost.
So, what are the considerations and trade offs? The most obvious observation is that both options strategies can be opened with a smaller capital outlay and have a clearly defined maximum risk. This immediately becomes attractive not only to a small account trader but also to the risk adverse trader that is looking, with certainty to define maximum loss. The trade off of course is that the trader buying the shares starts profiting immediately with a lower breakeven as there is no premium cost to owning the shares.
While there is considerable variation as to where a trader would place a stop loss on a long stock Dollarama position, it is fair to say any stop loss within the 1 standard deviation range of $8.68 is increasingly vulnerable to be triggered from ambiguous price action. Therefore, in my mind any reasonable stop loss would table a risk that is almost double the cost of the option premiums on both the long call and vertical debit spreads. One can openly debate that both option trades offer a far more attractive risk adjusted return potential for the circumstances and starting point for this trade.