This year has undoubtedly been a difficult market with plenty of whipsaw action. The easy money days of the last decade came to an abrupt halt as the Fed began to aggressively raise interest rates. Whereas buying and holding stocks and options served investors well in the past, this year it paid to shift to a strategy that benefits from volatile and swingy markets while simultaneously keeping risk at a minimum level.
Portfolio diversification isn’t just about spreading out risk to different asset classes, industry groups and sectors. Proper diversification involves implementing the right strategies that benefit from the current market environment; in other words,
adapting to our surroundings. The best traders adapt to what the market is doing. We can’t control the direction of the market, but we can control how we react to what the market gives us. Option Essentials
Before we analyze today’s trade, let’s review some option fundamentals as a refresher. My mantra when it comes to option investing is ‘keep it simple’. There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it is to work over the long run. Our aim is to utilize a strategy that is easy to follow and has a long history of profitability.
Options are standardized contracts that give the buyer the right, but not the obligation, to buy or sell the underlying stock at a fixed price which is known as the strike price. A call option is the right to buy a stock, fund or index, while a put option is the right to sell the same. The investor who purchases an option, whether a put or call, is the option buyer, while the investor who sells a put or call is the seller or writer.
These contracts are valid for a specific period of time and ends on expiration day. There are weekly options, monthly options, and even LEAPS options which are longer-term options that have an expiration date of greater than one year.
Below we’re going to explore a put option debit spread strategy. Purchasing a put option is bearish, with the goal to sell it at a higher price than we paid. Shorting a put option is bullish with the goal of buying it back at a lower price to realize a profit.
FedEx – The Zacks Rundown
FDX Quick Quote FDX - Free Report) is a Zacks Rank #3 (Hold) stock that has been steadily trending downward this year. FDX has fallen short of earnings estimates in 3 of the past 4 quarters, with an average miss of -6.78%. The company is part of the Zacks Transportation – Air Freight & Cargo industry, which ranks in the bottom 17% out of approximately 250 industries. In addition, FDX has an Earnings ESP (Expected Surprise Prediction) of -0.36%, pointing to a higher possibility of yet another earnings miss. Image Source: Zacks Investment Research
FedEx management has consistently warned this year of a weak macroeconomic backdrop along with giving negative guidance for future quarters. A number of Wall Street analysts have also sounded the alarm recently on the potential downside risk heading into the fiscal Q2 earnings announcement Tuesday after the bell.
A recent push higher for FDX stock off the September low gives us a solid entry point for our option spread trade. The option spread strategy presented below has one of the best overall risk/reward profiles. This strategy completely changes the game by creating an entirely new dimension of money-making opportunities, allowing us to profit even when the trade goes against us.
The put option debit spread is implemented by purchasing a put option and selling a related put option with a lower strike price. These types of trades are limited risk because the short option is ‘covered’ by the option purchase. When done correctly, trading options provides huge profit opportunities with limited risk.
Put Option Spread Strategy – A Lower Risk Alternative to Going Short
Put options are normally a better choice than shorting a stock outright. Shorting a stock has virtually unlimited loss potential if a stock continues to rally in price. Conversely, the maximum loss for a put option (and spread) is limited to the purchase price.
The table below displays the risk/reward profile for this trade. Here we are purchasing the January ’23 190-strike put, and selling the January ’23 175-strike put. The purchase (debit) costs 23.4 points, while the sale (credit) costs 11.95 points for a total cost of 11.45 points. Since options account for 100 shares of the underlying stock, the total cost for this spread trade is $1,145 as we can see in the orange highlighted box.
Image Source: Zacks Investment Research
The top (blue) row shows the performance of FDX stock based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our spread trade. We can see that if FDX goes down, remains flat, or even increases by 2.5%, this trade will realize a 31% profit. If FDX moves up 5% (goes against us as this is a put spread), we still would realize a 23.4% profit.
So we are baking in some downside risk here in the event that FedEx surprises to the upside on earnings. These are the types of odds I like to have on my side when trading options.
Advantages of Option Spreads 1) Does Not Require Large Price Movement to Profit
Even if FDX remains flat, we still enjoy a 31% profit in less than a month.
2) Less Overall Risk
The put option sold profits when FDX stock increases, providing us with a cushion. The sale of the 175-strike put reduced the risk of this trade from $2,340 to $1,145.
3) Allows Us to Maintain Positions During Volatile Markets
The downside protection provided from the put option sale helps us maintain our spread trade during periods of elevated volatility.
4) Introduces New Profit Dimension
There aren’t many times when we make money even when a trade goes against us. For this bearish put option spread, we can still profit even when FDX stock increases in price.
Option spreads are a safe way to use the leverage inherent in options. During this time of economic uncertainty and swingy market action, it pays to implement a strategy that can take advantage. I think the FDX example demonstrates why option spreads are an ideal investment!