Though it was a positive close on Wednesday, the market is still in a correction. That means caution and defense is paramount. With Starbucks stock approaching a 52-week high and showing improving relative strength, a bull call spread offers upside exposure while limiting the downside risk.
Starbucks found support at its 10-week moving average line and is testing resistance at 105. SBUX stock is also above its 21-, 50- and 200-day moving averages unlike most of the indexes. One way to take on bullish exposure without risking too much capital is via a bull call spread.
A bull call spread is created through buying a call and then selling a further out-of-the-money call. Buying the call gets you bullish exposure. Selling the further out-of-the-money call reduces the cost of the trade and therefore the risk. But it also limits the upside.
Setting Up The Bull Call Spread On Starbucks Stock
Going out to the April expiration, a 110 call option traded around 4.60 yesterday, and the 115 call was around 2.85. Buying the 110 call and selling the 115 call creates the bull call spread. Rather than a cost of $460 per contract, selling the 115 call brings in premium. That reduces the trade cost to $175 (the difference in the option prices multiplied by 100). Since the cost is also your maximum risk with the bull call spread, you've effectively reduced your risk on Starbucks stock.
As for the maximum potential profit, you have to give something up for that reduced risk. Rather than the unlimited potential from buying a call, your profit on Starbucks stock is capped at $325 (the difference in strike prices, multiplied by 100 less the premium paid). That's not too bad considering it equates to an 86% return on risk if Starbucks stock finishes at 115 or higher at the April 21 expiration.
But the key is that the bull call spread is a risk-defined strategy. If SBUX stock drops below 110 on April 21, the most the trade can lose is the roughly $175 premium paid. No matter how far the stock drops you can't lose anymore than what you paid. Options are already putting less capital at risk and the sold call lessens that capital requirement even more.
Trade Management
The break-even price for the trade is equal to the long call strike of 110 plus the premium. In this case that equals 111.75.
In terms of trade management, if the stock dropped below 97.50, I would consider closing early for a loss. If the trade is going against you, there's no reason to wait and take the maximum loss when you can cut it sooner.
According to the IBD Stock Checkup, SBUX stock is ranked 15th in its group and has a Composite Rating of 60, an EPS Rating of 40 and a Relative Strength Rating of 92.
Starbucks stock is due to report earnings in early February, so this trade has earnings risk if held until then.
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
