Merck stock has been one of the best market performers this year as the health care sector has been a strong relative performer.
According to the IBD Stock Checkup, Merck stock ranks No. 1 in its group and has a Composite Rating of 95, an EPS Rating of 93 and a Relative Strength Rating of 92.
Merck stock also shows improving relative strength on high volume. On Friday, the stock topped the 95.82 buy point of a flat base.
One bullish way to play the stock could be via a bull put spread.
As a reminder, a bull put spread is a defined-risk strategy, so you always know the worst-case scenario in advance.
Trade Works If Merck Goes Up, Sideways Or Even Lower
This type of trade will profit if MRK stock trades sideways or higher and even sometimes if it trades slightly lower.
With Merck shares trading around 95, if we use the November expiration, we can sell a 92.50 put and buy an 87.50 put for around $0.90 per share.
Selling this spread would generate roughly $90 in premium for a block of 100 shares, with a maximum risk of $410.
If the spread expires worthless that would be a 21.95% return in three and a half weeks, provided Merck is above 92.50 at expiration.
The maximum loss occurs if Merck closes below 87.50 on Nov. 18. That would see the premium seller lose $410 on the trade.
The break-even point for the trade is 91.60. That's 92.50 less the $0.50 option premium per contract.
In this market environment, I would set a pretty tight stop loss and close the trade if MRK drops below 92.
How To Limit Losses On Put Spread
Otherwise, another good rule of thumb is to limit the loss to the amount of premium received, which in this case would be $180.
Sticking to this stop loss level will help avoid large losses if the trade goes south. Merck reports earnings Thursday before the open.
Following last week's earnings announcement, an iron condor discussed last week for Procter & Gamble expired worthless for a full profit of 43%.
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
