McDonald's performed well following their earnings announcement on Tuesday, with the stock finishing 2.7% higher. Shares also are trying to climb past resistance near 260. So, let's look at an options strategy in the stock with very low risk on the upside and a healthy profit zone on the downside.
The strategy in McDonald's stock today: a broken wing butterfly. And we'll use puts because the strikes will all be below the stock price. This helps to reduce assignment risk.
With a regular butterfly option trade, the wings are placed an equal distance from the short strike.
But with a broken wing butterfly we leave a larger gap on a particular side.
McDonald's Stock: Constructing A Broken Wing Butterfly Trade
This results in less risk on one side and more risk on the opposite side.
Let's take a look at how a broken wing butterfly trade might be set up on MCD stock.
- Buy one Aug. 19-expiring 240 put at 1.05
- Sell 2 Aug. 19 250 puts at 2.65 each
- Buy one Aug. 19 255 put at 4.25
Notice that the upper strike of 255 is 5 points away from the middle-strike put with a 250 strike. And the lower-strike put at 240 is 10 points away from 250.
This broken wing butterfly trade will cost $0 to open, which means there is no risk on the upside.
Reward Vs. Risk
The worst that can happen is all the puts expire worthless leaving the trade with a flat return.
On the downside for this trade in McDonald's stock, calculate the maximum loss by taking the width between the first two strikes of 250 and 255 (5) multiplied by 100. That gives us 5 x 100 = $500. The maximum gain can also be calculated as 5 x 100 = $500.
The ideal scenario for the trade? MCD stock stays flat initially and then slowly drifts lower to close around 250 at expiration. The total profit zone is between 245 and 255.
As the trade in McDonald's stock starts with delta of 4, it has a slight bullish bias to start. But that will flip to negative delta closer to expiry if the stock is still above 255.
In terms of risk management, I would set a stop loss of 20% of the capital at risk, or if MCD broke below 245.
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
