Caterpillar looks like a potential bearish candidate after breaking below the 200-day moving average Wednesday.
The 50-day moving average is declining and sitting around 375, which could provide some short term resistance.
With the stock under pressure, I'm willing to bet that it will trade sideways at best over the next few weeks.
Today, I'm looking at a bear call spread. It assumes Caterpillar will struggle to get above the 380 level between now and the end of March.
A bear call spread involves selling an out-of-the-money call and buying a further out-of-the-money call.
The strategy can be profitable if the stock trades lower, sideways. It may even work if it trades slightly higher, as long as it stays below the short call at expiry.
Caterpillar Stock Trade Can Return $125
A March 21 expiry bear call spread on Caterpillar using the 380-390 strike prices can be sold for around $1.25.
Traders selling the spread would receive $125 in option premium. That's also the maximum possible gain. The maximum loss would be $875.
That represents a potential return of 14.3% between now and March 21.
The spread will achieve the maximum profit if Caterpillar closes below 380 on March 21. In this case the entire spread would expire worthless, allowing the trader to keep the $125 option premium.
The maximum loss will occur if Caterpillar closes above 360 on March 21. That would see the premium seller lose $875 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.
Managing Caterpillar Stock Option Trade
A stop loss could be set if Caterpillar trades above 370, or if the spread value rises from $1.25 to $2.50.
Because this is a bearish position, traders who think Caterpillar could move higher from here should not enter this trade. The position starts with a delta of -7, meaning it is roughly equivalent to being short seven shares of Caterpillar.
A bear call spread can also act as a small hedge for long stock holders.
According to the IBD Stock Checkup, Caterpillar stock is ranked No. 2 in its industry group. It has a Composite Rating of 51, an EPS Rating of 73 and a Relative Strength Rating of 50.
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 X/Twitter at @OptiontradinIQ
