Stocks are in a heavy downtrend and even bellwether stocks like Microsoft and Apple are getting hit.
Today, we are going to look at an advanced option strategy known as a call ratio spread using Microsoft stock.
This trade might be appropriate at a time such as this because it can be constructed with zero downside risk while also allowing for big gains if we get a strong bear market bounce.
Let's take a look at an example using MSFT stock.
-Sell to open 1 Microsoft June 275 call at 6.45
-Buy to open 2 Microsoft June 285 calls at 3.55
Maximum Potential Loss Is Small
Selling the 275 call generates $645 and buying the two 285 calls costs $710. Therefore, the trade costs a net debit of $65. This is the most the trade can lose if MSFT stays below 275. Not too bad. (An earlier version of this article contained incorrect cost and generation figures.)
If MSFT rallies, there is potential to make significant gains because of the extra bought call option. The faster any potential rally happens, the better.
The maximum potential loss comes if Microsoft stock ends right at 285 at the expiration date. In that case the trade could lose $1,055, so it's best not to hold the trade for too long if Microsoft is sitting around 285.
The maximum possible gain is unlimited.
The best-case scenario for the trade is a sharp rally in Microsoft stock early in the trade.
Try Simulating Complex Trades
If you are unfamiliar with this type of strategy, it is best to use option modeling software to visualize the trade outcomes at different dates and stock prices. Most brokers will allow you to do this.
The initial position has a net delta of 10, which means the trade is roughly equivalent to being long 10 shares of MSFT stock, although this will change as the trade progresses.
According to the IBD Stock Checkup, Microsoft is ranked No. 1 in its group and has a Composite Rating of 76, an EPS Rating of 93 and a Relative Strength Rating of 60.
Earnings are set for late July, so this trade should have earnings risk if held to expiration.
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
