The Dow Jones Industrial Average had its worst decline since November yesterday. McDonald's was one of the leading contributors to the decline. It took a huge tumble, down 4.9%, and closed at the low of the day. For investors that think the selling will continue, a bear call spread on McDonald's stock might satisfy their appetite.
Bear Call Spread On McDonald's 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 the stock trades lower, sideways, and even if it trades slightly higher. The key criteria is that it must stay below the short call at expiry.
As this is a bearish position, traders that think McDonald's stock could move higher from here should not enter this trade.
According to IBD Stock Checkup, McDonald's stock is ranked No. 20 in its group. Most of the ratings are weak with a Composite Rating of 48, an EPS Rating of 80 and a Relative Strength Rating of 58.
For McDonald's stock, an April expiry bear call spread could be set up using the 240 strike as the short call and the 250 strike as the long call. Yesterday, the 240/250 spread was trading around $1.55.
This is a credit spread meaning you receive the premium on the trade. That's yours to keep if McDonald's stock stays below 240, the short call, at expiration. With this Dow Jones component closing at 224 yesterday, it can go up quite a bit by expiration and still remain profitable.
The maximum profit on the trade is $155 per contract (1.55 premium x 100).
Assessing The Risk
What about the maximum risk? Some option trades have the risk of unlimited losses. Not this one. The bear call spread is a defined-risk trade. You know your worst-case scenario from the outset.
To calculate the maximum risk, take the difference between the strikes (10 in this case) less the premium received. Multiply that by 100 and the most you can lose is $845 per contract. That's an 18% return on risk in just over a month.
Bear Call Spread Summary
Again, the strike prices are your goal posts. The spread achieves maximum profit if MCD stock closes below 240 on April 14. The entire spread expires worthless and the trader keeps the $155 option premium.
The maximum loss occurs if McDonald's stock closes above 250 on April 14. At that point, your long call protects the losses from your short call. But you still lose $845 on the trade. That might seem like a large risk but keep in mind there is a lot of room that keeps the trade profitable.
A stop loss could be set if McDonald's stock trades above 250. Or you could set a stop based on the spread value doubling, rising from $1.55 to $3.10.
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
