Merck is showing high implied volatility at 32.3%, which is close to the highest level of volatility we have seen for this stock in 12 months. As option traders, we can take advantage of that by selling a "short strangle."
A short strangle involves selling an out-of-the-money put and an out-of-the-money call within the same expiration date. This trade generates a large amount of premium for the option seller, but it does come with risks.
A short strangle is an unprotected trade, sometimes referred to as a "naked" trade. Naked options can be risky as they expose the trader to potentially unlimited losses if the stock makes a big move.
However, if the trader is right and the stock moves sideways, the trader gets to keep the full premium.
Mastering The Short Strangle
Assuming a trader believes Merck stock will head sideways over the next few weeks, they could look to sell a May 30 put at 76 and a May 30 call at 86. The 76-strike put sold for around 1.38 a share this morning and the 86-strike call went for around 1.15 a share.
Selling those two options would generate a total of $253 in premium. That is also the maximum possible gain on the trade if Merck stock closes between 76 and 86 on the day of expiration.
To work out the break-even price of the trade, take the lower strike price of 76 minus the total premium received of 2.53, which equals 73.47. Then on the call side, take the call strike and add the premium, which gives 88.53. With Merck trading just above 80 this morning, that gives it a wide berth to move and remain profitable.
This trade is a short vega trade. It means if implied volatility increases early in the trade, losses could occur. A stop-loss could be placed at the short strike prices.
Short strangles are an advanced option strategy, so if all this sounds confusing, it's best not to trade them. With a trade like this, potential losses are unlimited and a lot higher than potential gains. That means traders should be highly confident the stock will remain flat over the course of the trade.
No Earnings Risk On Merck Stock
According to Investor's Business Daily's IBD Stock Checkup, Merck stock ranks No. 14 in its group. Also, it has a Composite Rating of 51, an EPS Rating of 66 and a Relative Strength Rating of 18. The top score in each category is 99.
Merck reported earnings on April 24, so this trade should have no earnings risk.
Please remember that options are risky, and investors can lose 100% of their investment.
Further, 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.
