As I mentioned in last week's pick, seasonality continues as a primary focal point for choices. With August being weaker generally, I will choose a weaker stock that sits at the bottom of the range in terms of overall strength. That choice is Merck, so today's column highlights a short call spread trade in Merck stock.
Merck, the pharmaceutical giant developing treatments for diabetes, obesity, respiratory and cardiovascular diseases, and women's health conditions, is performing poorly from a stock price perspective relative to peers Novo Nordisk, Novartis, and Indivior.
With the behemoth tech companies' earnings largely behind us, price behavior could easily slip into seasonal trends.
Therefore, for Merck stock, it looks less than appealing to take a long position in the current landscape after its latest earnings release.
IBD Stock Checkup shows Merck holding a dour Composite Rating of 40 on a scale of 1 to 99. In general, great stock picking centers around selecting those with a 90 Composite Rating or higher.
The Relative Strength Rating of 48 means that over the past 12 months, MRK has outperformed only 48% of the entire IBD stock database.
Meanwhile, Merck's ethical drugs group ranks 86th in a field of 197 industries tracked by IBD in terms of six-month relative price performance.
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Merck Stock Today: Setting Up The Bear Call Spread
The option toolbox notes that a short call spread, as a bearish position, forecasts that near-term prices are hitting their highs over the next 45 to 60 days.
Let's set up this trade in Merck stock in the following manner:
- Sell to open 1 MRK Sept. 15-expiration call with a 110 strike price
- Buy to open 1 MRK Sept. 15 120 call
The short call spread formation allows us to collect premium as prices fade or hold within its near term trading range between 103 and 109.
The Reward
Total credit received comes to $1.12 per spread, based on recent action.
This trade in Merck stock has limited risk and limited reward. The break-even price (before commissions) is $111.12 — the credit collected at the time of price entry.
Stock hunting using fundamental and price strength within the IBD methodology is where I firmly plant myself under the backdrop of current economic conditions. I also use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen in IBD.
Selling a call spread out of the money in a sideways-to-downside formation has high probabilities of expiring worthless, which is our goal. However, the reward is smaller.
So, traders who prefer to be option buyers might gravitate to a bear put spread strategy or a long put spread. In that vein, perhaps using the 105/95 strikes expiring in September will deliver more reward. But in the event of sideways or upside action, losses will accumulate quickly into risk thresholds. Thus, the risk of loss is higher with the long put spread, probability-wise.
Trade Management: First, Identify Key Chart Levels
The weekly resistance zone sits near 110 and support sits near 110. So, if Merck stock stays below 110, it will deliver the full profit of the spread. If prices fade, the spread will appreciate in value for us as it loses value.
Let's consider these scenarios for the short call spread:
- Merck stock grinds lower and we collect 50% or more of the credit collected, and you leave the trade.
- Stock grinds higher but does not breach 110 into expiration, and you collect the profit.
- MRK grinds higher, breaches 110 and stays there for more than four days. We leave the trade, or the spread values tests our risk parameters.
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
