Amazon is slated to report earnings on April 27. It may be a good time to take advantage of some volatility skew around that event. For Amazon stock, the diagonal put spread strategy involves trading options over different expiration periods and different strike prices.
The trade takes advantage of volatility skew by selling a short-term put option with high volatility. Then you buy a longer-term put with lower volatility.
When it comes to volatility, we generally want to buy low and sell high. Or sell high and buy low. So, let's look at an example in Amazon stock that will do well if the megacap e-commerce, retail and cloud-computing play stays above 92 between now and April 28.
Amazon Stock Today: Setting Up The Trade
The trade involves selling an April 28-expiration put option with a strike price of 95, then buying a May 12 put with a strike price of 90.
The short-term put has implied volatility of 56.3%. But the longer-term put in Amazon stock holds a lower ratio at 45.1%.
As of Tuesday's close, the April 28 put could have been sold for around 1.10 and the May 12 put option bought for 0.95.
This would result in a net credit on the trade of $15, which means there is no risk on the upside. The worst that can happen is that both options expire worthless, and the trader keeps the $15.
The risk on this Amazon stock trade is on the downside, with a potential maximum loss of $485. Calculate this by taking the difference in the spread (5) multiplied by 100 and subtracting the premium received (15).
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Risk Vs. Reward
The maximum potential gain is around $185, which would occur if AMZN closes right at 95 on April 28.
Aiming for a return of around 10% to 15% makes sense, and I would set a similar stop loss.
The worst-case scenario? A sharp drop in AMZN stock early in the trade. For this reason, if the stock drops below 95 in the next few days, I would also consider closing the trade early to minimize losses.
The initial trade setup has a delta of +6. This means the position is roughly equivalent to owning six 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 No. 16 in its group. It shows a Composite Rating of 36, an EPS Rating of 14 and a Relative Strength Rating of 30.
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
