After Fed Chair Jerome Powell sent a significant, dovish message to the market this week, it may be worth revisiting the calendar wheel strategy. This week we'll take a look at DRI stock as it reacts to earnings.
We had the highest number of stocks hitting 52-week highs that we've seen for a while as we head into a quadruple witching options expiration. The market trend analysis in IBD shows a confirmed uptrend at the moment. Why the calendar wheel on Darden Restaurants here? I'm looking at the potential to deliver upside profits long term over the potential gyrations we might see in the near term. The calendar spread allows the flexibility for short-term weakness but leaves us open to unlimited upside if price action remains bullish.
DRI stock reported earnings this morning and after an initial dip at the open it quickly recovered ground. Historically, DRI stock has seen participants buy the dip over the last few years.
DRI Stock Today: Setting Up A Calendar Spread
Within the options toolbox, the long call calendar spread is a neutral-to-bullish position. It estimates that the near-term prices are within a range but will rise over the longer term.
Let's set up a long calendar spread in DRI stock in the following manner:
- Sell to open 1 DRI Jan. 19-expiration call with a 165 strike price
- Buy to open 1 DRI Feb. 16 call at the same strike of 165
At the lows today that total debit came out to $1.10 per share per set of contracts. The spread is trading about 30 cents higher now at $1.40. This means we calculate a break-even cost at $166.40. That is, take the price of the long option strike in DRI stock plus the strike of the option. Because we are using options with different expirations, they are referred to as calendar spreads.
The ideal strategy gives us three scenarios to exit the trade.
Exit Strategies
First, you could sell the entire calendar spread once it carries an acceptable profit. This can happen early in the cycle with a very large move upward in price. At which point it's often best to just lock in the profit while you have it rather than wait. A lot can happen while that expiration approaches and you could lose a lot of profit while waiting to capture just a tiny bit more.
Two, watch the support levels. Let's imagine that DRI stock pulls back but doesn't break that critical support near 147.50. You could see the January expiration come about for the short 165 calls, which would expire worthless. That leaves you with the February calls remaining on the long side. You would have the position free and clear to participate in any upside.
Finally, if DRI stock fails the critical support near 147.50 and stays below this line for more than three days, it is likely that the chart will fade more. Rather than take the full loss, it would be a fair place to exit the trade.
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Please note the cost of the calendar will increase if you move the strikes further out of the money.
Stock hunting using fundamental and price strength within the IBD methodology is where I firmly plant myself under the backdrop of the current economic situation. I use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen on IBD.
Buying a calendar spread assumes price action will be somewhat sideways to up (in our current configuration) in the short term. But it also assumes that DRI stock will break out to the upside as we approach the strike price and get closer to the expiration of the furthest month. In this case, it is February we are looking at.
Options sellers are positioned to win in two ways: the stock does nothing, or it moves within the ranges. We use this concept to minimize the risk of market exposure.
Managing The Options Trade For DRI Stock
First, let's identify key chart levels in DRI stock.
The monthly resistance zone sits near 175, and support sits near 147. Don't forget to analyze the recent history of a chart. Darden has had the prior behavior pattern of dipping right after earnings and then finding that support and continuing to the north. This is one of the main reasons I like this calendar formation.
Scenarios for the DRI stock long call calendar spread:
- Stock gaps lower after earnings, breaks the 147 support price for more than five days (the average motion after earnings on a fade) and shows no sign of recovering. This is an exit point. You can exercise a little patience but not much. Traders customarily buy the dip here with routine.
- DRI stock gaps up much earlier in the cycle and the option position increases in value by more than 30%. We could certainly choose to sell the entire position and quickly take the gains, freeing up more capital to trade.
- Stock grinds higher but does not break the 165 strike into the January expiration. This will tell us we are in range and can continue to hold the February call that should deliver returns.
Final Thoughts
As with all trades, consider what you like about holding the position in the first place and consider your risk carefully.
Be patient and allow price action to move around a range of your stops.
Anne-Marie Baiynd is a 20-year veteran trader of stocks, options and futures and is the author of "The Trading Book: A Complete Solution to Mastering Technical Systems and Trading Psychology." She holds no positions in the investments she writes about for IBD. You can find her on Twitter and Stocktwits at @AnneMarieTrades
