Micron Technology stock moved back above its 50-day moving average Thursday and is due to report earnings March 20. Its volatility skew is high due to the pending report with short-term options showing higher implied volatility than long-term options. One way to take advantage of this skew — a diagonal put spread.
This is an advanced strategy because it utilizes options over different expiration periods and varying strike prices.
Let's look at an example: Traders could sell a March 21 put with a strike price of 85 and buy an April 4 put with a strike price of 83. As of yesterday's close, the March 21 put could be sold for around $1.90. The April 4 put could be bought for $2.35.
The trade would result in a net debit of around $1.45, meaning little risk on the upside. The worst thing that can happen is the puts expire worthless and the trader loses the $145 in premium paid.
Micron Stock: Here Are The Risks
The risk on the trade is on the downside with a potential maximum loss of $345. This results from taking the difference in the spread, $2, multiplied by 100 and adding the $145 premium paid.
The maximum potential gain is around $400 which would occur if Micron stock closes right at 85 on March 21. The break-even price is estimated at around 77.60. The trade will do well if shares stay above 85 for the next week or so.
Aiming for a return of around 10%-15% makes sense and investors would be wise to set a similar stop loss. The worst-case scenario is a sharp drop in Micron stock early in the trade. For this reason, if the stock drops below 85 in the next week, investors should also consider closing the trade early to minimize losses.
The initial trade setup has a delta of zero, meaning the position is direction neutral to start. Note that this delta number can change significantly as the stock starts to move.
Higher Volatility In Selling
One of the advantages of the trade is that the put we are selling has higher volatility, at 102%, than the put we are buying at 79%. Just like stocks, when it comes to volatility, we want to buy low and sell high. Closing before the company's quarterly report is a good idea to avoid earnings risk.
According to Investor's Business Daily's IBD Stock Checkup, Micron stock ranks second in its group and has a Composite Rating of 66, an EPS Rating of 80 and a Relative Strength Rating of 27.
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. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
