Oracle stock has pulled back after a healthy uptrend from mid-April to early August and is set to report fiscal second-quarter earnings in early September.
Volatility skew is high due to the pending earnings announcement with short-term options showing higher implied volatility than long-term options.
One way to take advantage of this skew comes via a diagonal put spread. This option strategy is an advanced strategy because it utilizes options over different expiration periods and different strike prices.
Let's look at an example.
How To Buy And Sell The Put
Traders could sell a Sept. 12 put with a strike price of 205 and also buy a Sept. 26 put with a strike price of 200. As of Wednesday's close, the Sept. 12 put on Oracle stock could be sold for around $2.60 a share and the Sept. 26 put could be bought for $2.70 a share.
The trade would result in a net debit of around 10 cents a share which means there is very little risk on the upside. The worst thing that can happen is the puts expire worthless and the trader loses the $10 in premium paid for a 100-share contract.
Meanwhile, the risk on the trade is on the downside with a potential maximum loss of $510. Calculate this by taking the $5 difference in the spread multiplied by 100 and adding the $10 premium.
The maximum potential gain is around $625 which would occur if Oracle closes right at 205 on Sept. 12. The break-even price comes in around 192. The trade does well if Oracle stock stays above 205 for the next week or so.
Aiming for a return of around 10%-15% makes sense and it's best to set a similar stop -loss. The worst-case scenario is a sharp drop in Oracle stock early in the trade. For this reason, if the stock drops below 205 in the next week, I would also consider closing the trade early to minimize losses.
The initial trade setup has a delta of 2, meaning the position is roughly equivalent to owning two shares of Oracle stock. Note that this delta number can change significantly as the stock starts to move.
Oracle Stock: Handling The Volatility
One of the advantages of the trade is that the put we are selling has higher volatility (68%) than the put we are buying (56%). Just like stocks, when it comes to volatility, we want to buy low and sell high.
Closing before the earnings date in early September is a good idea to avoid earnings risk.
According to IBD Stock Checkup, Oracle stock ranks No. 4 in its group. Further, Investor's Business Daily gives it a Composite Rating of 87, an EPS Rating of 69 and a Relative Strength Rating of 92.
It's important to 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, and is conservative in his style. He also believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ.
