Despite the pullback, the stock market continues to maintain its confirmed uptrend. And as Federal Reserve Chair Jerome Powell testified on the floors of the House and the Senate this past week that interest rates are likely holding steady for another month, we are now in a grinding state of motion. So my gravitation is to the IBD Long Term Leaders and insurance broker Gallagher. Let's consider a custom butterfly spread trade in Gallagher stock.
Gallagher stock boasts solid IBD ratings, including a 95 Earnings Per Share Rating on a scale of 1 to 99. According to IBD Stock Checkup, the Composite Rating stays sharp at 91.
I remain keen on exploring options that will allow me to participate with controlled downside as the major swing I saw in sentiment this past week sends me a warning shot across the bow of the ship.
Gallagher Stock Today: Setting Up A Complex Butterfly
As we look at the option toolbox, the custom butterfly strategy positions me for upside while reducing overall exposure to risk. The goal here? Participate in upward motion with limited risk as the prices continue to extend sharply.
Investors placing trades may consider this custom butterfly spread as follows:
- Buy to open 1 AJG Aug. 18-expiration call option at a 210 strike price
- Sell to open 3 AJG Aug. 18 220 calls
- Buy to open 2 AJG Aug. 18 230 calls
This butterfly formation allows us to take advantage of upside pressure that might appear over the summer. Then, we may use the proceeds from the call credit spreads to pay for the in-the-money call strike. Note that at this writing, the call is currently in the money.
Based on recent action in AJG options, the total debit spent comes out to $.50 per spread. This trade has a total risk of $50 for a block of 100 shares, so long as prices do not expand above 220. The break-even price (before commissions) is 210.50.
The maximum return? Take the difference between the call strikes, less the premium, to get $9.50 overall, or equal to $950 per set of contracts.
Stock hunting using fundamental and price strength within the IBD methodology of stock selection is where I firmly plant myself under the backdrop of the current economic backdrop. I also use technical analysis to find ideal buying opportunities in conjunction with the tools for strength seen on IBD. Gallagher holds these but it is also having trouble at its resistance zones. Any bursts of price could push us to the next leg up, but if the price action fades, our debit exposure is limited.
Understanding The Combo Spread
This spread holds long call spreads and short call spreads. The trade, therefore, allows me to enter as the price rallies with a small debit of $.50 at the 210 strike, while the outright purchase for the 210 call strike expiring on 18 Aug is currently $8.20. The flip side is that we have a bounded reward; it cannot deliver more than $950.
The break-even price for this spread is 210.50.
The weekly near-term resistance zone sits near 220 and the spread formation will begin to erode into negative returns if prices move above 219.50. Meanwhile, price action support sits near $200.
Scenarios For This Custom Spread Trade
What could happen? Consider these scenarios.
First, Gallagher stock moves higher and sits over 210 but does not rise above 220 into expiration and I make the maximum amount of $9.50 per share. Second, the stock moves lower. I lose 50% of the price of the premium of $.50 and I exit the trade.
Third, AJG stays within the region between 210 and 220 and the premium doubles at which point I will cut my position in half and then trail the rest up into the tripling — then we hit rarefied air and should manage the trade much more tightly.
Set an alert for the prices on the edge (near 220) and if it triggers, consider taking profit quickly if the expiration is close.
As with all trades, consider what you like about holding the position in the first place and consider your risk carefully.
Anne-Marie Baiynd is a 20-year veteran trader of stocks, options and futures and is the author of "The Trading Book: A Complete Solution to Mastering Technical Systems and Trading Psychology." She holds no positions in the investments she writes about for IBD. You can find her on Twitter and Stocktwits at @AnneMarieTrades
