Amazon has had a tough few weeks, with the stock dropping from 120 to 90 following a disappointing earnings announcement. When Amazon stock, representing a quality company, has a big drop like this, I like to use a strategy called a diagonal put spread.
Note that this option strategy is an advanced strategy. Why? It utilizes options over different expiration periods and different strike prices. Let's look at the Amazon example.
How To Set Up A Bearish Diagonal Put Spread
The trade I'm looking at is selling a Dec. 16-expiration put option with a strike price of 80 and buying a Jan. 20 put with a strike price of 75.
As of Tuesday's close, the Dec. 16-expiration put in Amazon stock sold for around $1.75 per contract. A trader could have also bought the Jan. 20 put for $1.90. The net cost on the trade would be $15; that is the most the trade could lose on the upside.
The risk on the trade: a potential maximum loss of $515. You can calculate this by taking the difference in the spread (5) multiplied by 100 and adding in the cost of the trade (15).
The maximum potential gain for this diagonal put spread trade in Amazon stock reaches around $250. That would occur if AMZN closes right at 80 on Dec. 16, when the monthly option expires.
Amazon Stock Today: Risk Vs. Reward
The trade holds a nice profit zone from 77 to 98. Aiming for a return of around 10% to 15% makes sense. And I would set a similar stop loss.
The worst-case scenario involves a sharp drop in AMZN stock early in the trade. For this reason, if the stock drops below 80 in the next few days, I would also consider closing the trade early to minimize losses.
The initial trade setup has a delta of 3. This means the position is roughly equivalent to owning three shares of AMZN stock. Note that this delta number can change significantly as the stock starts to move.
According to IBD Stock Checkup, Amazon stock ranks 11th in its group and has a Composite Rating of 34, an EPS Rating of 64 and a Relative Strength Rating of 16.
Elsewhere, let's review some recent trades.
A UnitedHealth unbalanced iron condor is looking great and can be closed early, as can this bull put spread on Merck. However, this bear call spread on Advanced Micro Devices was stopped out Tuesday.
Please remember that options are risky and investors can lose 100% of their investment.
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
