3M dropped back below the 50-day moving average last week, and continued to tumble on Tuesday. Shares also closed near the low of the day. Such bearish action provides an opportunity to play a bearish spread trade in 3M stock.
3M stock is also showing weak relative strength. The St. Paul, Minn.-based manufacturing giant and Dow Jones Industrial Average component faces thousands of lawsuits from a host of U.S. municipalities and public water suppliers.
Therefore, traders who think MMM will not reclaim the 50-day line in the next few weeks could look at a bear call spread in options. The 50-day moving average for 3M stock currently lies at 101.17.
A bear call spread involves selling an out-of-the-money call and buying a further out-of-the-money call.
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The strategy can be profitable if the stock trades lower, sideways and even slightly higher, as long as it stays below the short call at expiry.
On Tuesday, a bear call spread in 3M stock using call options for the July 21 expiration and at the 100 and 105 strike prices was trading around $1.30. During Wednesday afternoon trading, that spread stood virtually unchanged.
So, traders selling the spread in 3M stock would receive $130 in option premium per set of contracts. That marks the maximum possible gain. The maximum loss? It comes out to $370. To calculate this, take the spread between the two options, or 5, and subtract by 1.3 to 3.70. Multiply by 100 to get $370.
The spread will achieve the maximum profit if MMM closes below 100 on July 21, in which case the entire spread would expire worthless. This event allows the trader to fully keep the $130 in option premium.
The maximum loss will occur if 3M stock closes above 105 on July 21, which would see the premium seller lose $370 on the trade. While some option trades have the risk of unlimited losses, a bear call spread is a risk-defined strategy, and you always know the worst-case scenario in advance.
Where To Set A Stop Loss
A stop loss could be set if the spread value rises from $1.30 to $2.60.
As this is a bearish position, traders who think 3M stock could move higher from here should not enter this trade.
The position starts with a delta of -29, meaning it is roughly equivalent to being short 29 shares of MMM stock.
According to IBD Stock Checkup, 3M stock is ranked No. 17 in its group and has a Composite Rating of 23, an EPS Rating of 49 and a Relative Strength Rating of 19.
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
