Home Depot dropped below the 200-day moving average Wednesday and could be a good candidate for a bearish trade.
Today, I'm looking at a bear call spread on Home Depot stock. This can also act as somewhat of a hedge on a long-term stock position.
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, and even if it trades slightly higher, as long as it stays below the short call at expiry.
A September expiry bear call spread on Home Depot stock using the 370-375 strike prices can be sold for around $0.90.
Traders selling the spread would receive $90 in option premium, which is also the maximum possible gain. The maximum loss would be $410.
Potential Return Of 22%
That represents a potential return of 21.95% between now and mid-September.
The spread will achieve the maximum profit if Home Depot closes below 370 on Sept. 20. It that case the entire spread would expire worthless, allowing the trader to keep the $90 option premium.
The maximum loss will occur if Home Depot stock closes above 375 on Sept. 20, which would see the premium seller lose $410 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.
A stop loss could be set if Home Depot trades above 365, or if the spread value rises from $0.90 to $1.80.
Roughly Equivalent To Shorting 4 Shares
Because this is a bearish position, traders that think the stock could move higher from here should not enter this trade. The position starts with a delta of -4, meaning it is roughly equivalent to being short four shares of Home Depot stock.
According to the IBD Stock Checkup, Home Depot stock is ranked No. 2 in its industry group. It has a Composite Rating of 56, an EPS Rating of 65 and a Relative Strength Rating of 58.
The company reports Q2 earnings on Aug. 13 before the market open, so this trade would have earnings risk if held to expiration.
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
