The markets have been on a tear since the latest CPI numbers and the bounce has been fierce. With that in mind, let's take a close look at Home Depot and consider how we could take advantage of a potential long-term rise in Home Depot stock by going long in a calendar spread in options trading.
Home Depot stock is trading tightly in recent days after a bullish reaction to its fiscal third-quarter results on Tuesday. The megacap retailing play is now forming a new base.
HD holds a so-so IBD Composite Rating of 66, so this deserves watching closely.
Meanwhile, the Relative Strength Rating of 46 has fallen from a respectable 81 three months ago, on a scale of 1 to 99. A continued advance in Home Depot stock should boost the RS score. As seen on the technical panel in a MarketSmith chart, the 6-month Relative Strength Rating fares better at 58.
Fast moves make me a wee nervous, so my approach remains guarded for a full deployment of capital. Under the current backdrop, however, we have seen the bonds rally and housing stocks catch buying interest along with small caps. All of this implies there is more upside to go.
Though it is still my estimation that jagged price action will continue, I am confident that finding the right entry point will deliver stellar results. And in the options landscape, finding a way to sell premium over time will bring me just what I am looking for, entries in quality stocks at reasonable prices.
As I often do, I will focus on the monthly charts as the most relevant, particularly when we look at the calendar spreads with several months separating our strike expirations.
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Home Depot Stock Today: The setup
Going to today's chart action in Home Depot stock and with earnings and guidance for the next quarter behind us, we can anticipate the stock will be bought on the dips. This may be particularly if the stock market itself "holds the bid."
Inside the option toolbox, the long calendar spread portrays a neutral to bullish position. It estimates that near-term prices in Home Depot stock are within a range but will rise over the longer term.
Let's consider the long calendar spread for Home Depot stock with these strike prices:
- Sell to open 1 HD Dec. 15-expiration call with a 310 strike price
- Buy to open 1 HD Mar 15 310 call
The Break-Even Level
Total debit for this trade comes out to $5.88 per set of contract, based on recent trading. Therefore, we see a break-even cost for the trade in Home Depot stock at 315.88. That is, take the price of the long option paid plus the strike of the option. (During Friday's action, the total debit topped $9.50.)
Because the two options' strikes are separated by time and do not expire at the same time, I will always refer to these as calendar spreads.
What do we want to see in the ideal unfolding of time?
As we get to a week before expiration, we will buy the December 310 call back, and then sell the January 310 calls while still holding the March 310 calls.
Why? This strategy will reduce the break-even point and increase our profit potential in Home Depot stock over time. The goal with this trade: create a credit that will make the strike in March 'free' or for a credit.
Plus, we achieve future unlimited upside in the trade overall if the February-expiring 310 calls (not yet in the option chains at the start of this trade) expire worthless. I put the term "free" in quotations because the deployment of any capital always involves opportunity cost of some kind.
Inside IBD's Big Picture Stock Market Column
Defending The Trade
Stock hunting using fundamental and price strength within the IBD methodology is where I firmly plant myself under the backdrop of the current economic backdrop. I use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen on IBD.
To understand the long call calendar spread, we can also think of it as a wheel. In other words, we choose to roll the option strike each month approximately one week before expiration.
Buying a calendar spread surmises price action will be somewhat sideways to up (in our current configuration) in the short term, but will break out to the upside once the strike of the furthest month gets closer to expiration. In this case, it is in March. Options sellers are positioned to win in two ways — the stock does nothing, or the stock moves within the ranges, so we use this concept to minimize the risk of the market exposure.
Additionally, because we have time positioned as an ally and not the enemy, if prices move up sharply as they did with the JPMorgan Chase position from last week, the calendar spread is pricing in 40% higher at the current glance even as the short call is in the money.
"In the money" means the price of the stock is higher than the option strike.
Trade Management: Key Home Depot Stock Levels
The monthly resistance zone sits near 350, and support sits near 244. If we see some sharp dips, we will be in position to move the options to collect premium.
Scenarios for the HD long call calendar spread
- Home Depot stock grinds lower but does not break the 250 price level for more than three days. The stock shows itself as favorable to the traders looking for longer term growth. We should look for bounces in the days following to confirm the strength of the chart.
- HD grinds higher much earlier in the cycle. The option position increases in value by more than 50%. Here, we could certainly choose to sell the entire position and quickly take the gains, freeing up more capital to trade.
- Home Depot stock grinds higher but does not break 350 for more than three days. It shows traders are not willing to pay more for the stock at the present time. This also tells us we are in range and can continue to sell premium against the strike in March.
- Stock breaks out of either of these levels for more than three days and breaks our personal risk thresholds for the trade. Thus, we exit the trade. Be patient when we get close to the strikes. Why? Patience will pay off in these formations. This becomes markedly more important the closer we get to expiration.
- Home Depot stock holds a price within the range of our short strike before each prior month's expiration until finally all we hold is the long March 310 calls. This way we can sell three months' worth of call premium. And this potentially makes our break-even level well below 310 with unbounded upside.
Final Analysis
Please note not to fret too much if the short strike goes into the money early in the cycle.
We can always roll to higher prices to protect the future investment of the long March strike. Or, we can close the position for a likely profit. Time decay will be our friend if this happens in the first 30-45 days of the position cycle.
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
