Amazon is showing improving relative strength and on Monday, it broke back above its 200-day moving average. Now, investors who think Amazon stock will continue to rally could also do so with reduced risk, via the use of options.
A bullish diagonal spread allows traders to get long Amazon without risking too much capital. A bullish diagonal spread is a trade that involves buying a long-term call option and selling a shorter-term, out-of-the-money call option against it.
Here's how to use the spread to find a favorable risk to reward trade on the assumption that Amazon stock might move toward 215 in the next few weeks.
How A Diagonal Spread Works For Amazon Stock
Buying the Sept. 19, 190-strike call will cost around $2,785. Therefore, selling the May 16, 215-strike call option will generate around $5.80 in premiums.
That results in a net cost for the trade of $2,205 per spread, which is the most the trade can lose.
The estimated maximum profit is estimated at around $1,120, but that can vary depending on changes in implied volatility. The maximum profit would occur if Amazon closed right at 215 on May 16 and represents a return of around 51%.
The idea with the trade is that if Amazon stock trades up to around 215, the diagonal spread will increase, resulting in a net profit.
Upside Exposure With Less Risk
A bullish diagonal spread is a good way to gain some upside exposure on a stock without risking too much if the move doesn't eventuate.
The combined position has a net delta of 33. That also means the trade is roughly equivalent to owning 33 shares of Amazon stock. But this will change as the trade progresses.
The suggested stop loss level is a close below Friday's low of 192.52.
According to the IBD Stock Checkup, Amazon stock is ranked number 11 in its group. Further, it has a Composite Rating of 82, an EPS Rating of 78 and a Relative Strength Rating of 64.
Earnings Risk Is Possible
Amazon is due to report earnings in late April or early May. Thus, this trade would have earnings risk if held to expiration.
It's important to 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. Further, investors should remember to always do due diligence and consult financial advisors before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options and conservative in his style. He believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ.
