Home Depot stock hit resistance and a declining 200-day moving average and is now dropping. HD stock is also a member of the Dow Jones Industrial Average, which briefly poked its head above the 200-day line before the Dow Jones index started its latest decline. Traders that think Home Depot stock has further downside might consider a bear call spread to profit.
Setting Up A Bear Call Spread In HD Stock
A bear call spread involves selling an out-of-the-money call and buying a further out-of-the-money call.
The strategy can be profitable if Home Depot stock trades lower, sideways, and even if it trades slightly higher. As long as it stays below the short call at expiry.
Yesterday, a bear call spread on HD stock traded around $1.40 using a short call at 330 and long call at 335. Both calls have an Oct. 21 expiration.
Traders selling the spread would receive $140 in option premium. That becomes yours to keep, if the trade goes the right way.
Profits, Losses And Managing The Trade
The spread achieves the maximum profit if HD stock closes below the short strike of 330 on Oct. 21. In that case the entire spread expires worthless and the trader keeps the $140 option premium.
The maximum loss occurs if HD closes above the long strike of 335 on Oct. 21. There, the premium seller loses $360 on the trade. That's the difference between the strikes multiplied by 100 less the premium received.
With a $140 profit potential and $360 at risk, that gives you a 38.8% return on risk.
While some option trades have the risk of unlimited losses, a bear call spread is a risk-defined strategy. You always know the worst-case scenario in advance.
A stop loss could be set if HD stock trades above 325, or if the spread value doubles from $1.40 to $2.80.
As this is a bearish position, traders that think HD stock could move higher from here should not enter this trade. The position starts with a delta of -6, meaning it's roughly equivalent to being short 6 shares of HD stock.
According to IBD Stock Checkup, HD stock ranks No. 13 in its group and has a Composite Rating of 79, an EPS Rating of 89 and a Relative Strength Rating of 59.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
