With the market under pressure, it's not the type of environment to be aggressively bullish. But with CAT stock holding up well, you could use options to give a more subdued outlook. The iron condor is usually for a neutral outlook but the unbalanced iron condor allows you to take a slight directional bias.
Reasons For Bullishness On CAT Stock
Caterpillar is a Dow component that doesn't often get the attention of growth investors. But it's hard to ignore the strong relative strength and high ratings. According to the IBD Stock Checkup, CAT stock is ranked No. 1 in its group. It has an IBD Composite Rating of 97, an EPS Rating of 85 and a Relative Strength Rating of 94.
For the last month, CAT stock has traded sideways in a flat base. A strong support level is offered around 225 and so far it's resisting the downward move of the market.
So rather than the neutral iron condor, we can massage the distance between the strikes on the put spread to create an unbalanced iron condor. That gives the trade a slightly bullish bias.
Unbalanced Iron Condor Setup
As a reminder, an iron condor is a combination of a bull put spread and a bear call spread. We'll go wider on the strikes in the bull put spread to create the bullish bias. We'll collect more premium, but that comes with a greater risk if the trade falls.
First, we take the bull put spread. Using the Jan. 20 expiry on CAT stock, we sell the 220 put and buy the 210 put. That spread sold for around $1.80 on Friday.
Then the bear call spread. Using the same expiration, sell the 250 call and buy the 255 call. This spread sold for about 60 cents on Friday.
Notice, we are getting more premium from our bull put spread than the put spread. Also, the distance between the strikes is 10 points wide on the put spread and only five points on the call spread. This gives the trade a slight bullish bias, but also more risk on the downside.
In total, the unbalanced iron condor on CAT stock generates around $2.40 per stock, or $240 of premium per a 100-share block contract.
Risks And Returns
The profit zone ranges with CAT stock between 217.60 and 252.40 at expiration. Calculate this by taking the short strikes and adding or subtracting the premium received.
The maximum profit occurs if the options expire worthless by trading between the short strikes. In that case, you keep the entire premium.
The maximum risk is $760 on the put side and $260 on the call side. To calculate the maximum risk, you take the difference between the strikes and subtract the total premium received. It's different for each spread since the put spread is wider.
If we take the premium ($240) divided by the maximum risk ($760), this iron condor trade has the potential to return 32%.
A stop loss in this case might be calculated based on 25% of capital at risk, so a loss of around $190.
Please remember that options are risky, and investors can lose 100% of their investment.
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
