Enterprise software company Datadog fits well within the confines of what to look for — good yield in short duration with limited risk. Therefore, investors may want to examine a butterfly spread trade in DDOG stock.
Market participants have responded positively as encouraging news of economic growth continues in front of inflation data and the next Fed meeting concerning rates. I notice that the slope of motion is slowing somewhat as we close the June month, the second quarter and the first half of the year. Therefore, it makes sense to explore stock market leaders profiled by IBD and hunt for stocks that have triggered buy zones.
When charts give such a bullish look like the way they do currently, I sit in the butterfly garden in the world of options trading. So, once again this will be our formation to explore.
DDOG Stock Today: Excellent Industry Group
Using option configurations that allow participation of an uptrend in DDOG stock and other tech leaders with controlled downside remains an anchor for choosing a trade strategy. Why? The slope of motion slows while still trending upward in price.
Meanwhile, bullish sentiment readings continue to be overheated near all-time highs.
As we look at the option toolbox, the butterfly trade positions us for upside while reducing risk exposure. The goal? Participate in the upward motion of DDOG stock with limited risk as the prices continue to extend, though not as sharply.
Setting Up The Butterfly Trade
The butterfly spread for DDOG stock, ranked No. 8 in the enterprise software group in terms of overall IBD metrics, could be set up in this fashion:
- Buy to open 1 DDOG July 21-expiration call at a 90 strike price
- Sell to open 2 DDOG July 21 100 calls
- Buy to open 1 DDOG July 21 110 call
This butterfly formation allows us to take advantage of upside pressure that might appear over the summer. Also, we may use the proceeds from the call credit spreads to pay for the in-the-money call strike. Note that at time of this writing, the call in DDOG stock, at 99.37 in Friday afternoon trading, currently sits well in the money in terms of the low strike price of 90 in this setup.
Total debit spent is $3.65 per spread, based on recent action. This trade has a total risk of $3.65, irrespective of price movement. Therefore, the break-even price (before commissions) is $93.65 in DDOG stock.
The maximum return occurs if contracts are closed at expiration and Datadog closes at 100. To calculate the gain, take the difference between the call strikes less the premium, or 100 minus 90, minus the premium paid of $3.65, for a maximum return of $6.35, or $635 for the set of contracts. This would achieve a 74% return in three weeks.
Defending The Trade In DDOG Stock
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.
DDOG stock holds these traits. But expectations of slowing motion and a cooling in the tech sector rally drive the trade analysis. Any bursts of price could push us to the next leg up, but if the price action fades, our debit exposure is limited.
This spread holds long call spreads and short call spreads that allow me to enter as the price rallies with a small debit of $3.65 for exposure at the 90 strike, deep in the money at this writing, while the outright purchase for the 90 call strike expiring on July 21 recently hit $8.25 per contract. The flip side? We have a bounded reward; it cannot deliver more than $6.35 if we close the entire butterfly as we entered it.
As for managing the trade, let's identify key chart levels. The weekly near-term resistance zone sits near 100. So, the spread formation will begin to erode into negative returns if prices move above 100. Price action support sits near 90.
Scenarios For The Butterfly Spread
What could happen?
- DDOG stock moves higher and sits at 100 into expiration; I make the maximum amount of $6.35 per set of contracts.
- Stock moves lower and I lose 50% of the price of the premium of $3.65; I exit the trade using simple stop-loss rules.
- Datadog stays between 98 and 100 and the premium boost should statistically be 70% higher; exit the position.
- Set an alert for the prices on the edge (near 100); if it triggers, consider taking profit quickly if the expiration is close.
Advanced Topic
Consider this alternate exit strategy. If the chart tests the 100 price level next week and rejects it but holds $96 as it bounces higher, you can consider closing the long call spread and take the full available profit on one side of the butterfly, while leaving the short call spread to expire worthless.
This requires a bit more watching. However, yields could significantly improve using this technique.
As with all trades, consider what you like about holding the position in the first place and consider your risk carefully.
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
Please follow Chung on Twitter: @saitochung and @IBD_DChung
