PayPal has been in a nasty downtrend since July. So let's look at how to set up a bearish option trade in this stock: the bear call spread.
PayPal stock closed off the lows Tuesday. But unlike many other stocks, the former member of IBD Long-Term Leaders could not finish in the green.
How To Set Up A Bear Call Spread
A bear call spread involves selling an out-of-the-money call and buying a further out-of-the-money call.
The strategy can turn profitable if the stock trades lower, sideways and even if it trades slightly higher. The key here: PayPal stays below the short call at expiry.
On PayPal stock, set up a February-expiration bear call spread using the 170 strike as the short call and the 175 strike as the long call.
On Tuesday, that spread traded around $1.35 on the monthly call options. If executed at that price, a trader would pocket a maximum profit of $135 per contract with a maximum risk of $365.
The spread will achieve the maximum profit if PayPal stock closes below 170 on Feb. 18, in which case the entire spread would expire worthless, allowing the trader to keep the $135 option premium.
PayPal Stock Reward Vs. Risk
The maximum loss will occur if PayPal closes above 175 on Feb. 18, which would see the premium seller lose $365 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 PYPL trades above 170, or if the spread value rises from $1.35 to $2.70. As this is a bearish position, traders that think PayPal stock could move higher from here should not enter this trade. Traders may also prefer to wait until after the Fed meeting's announcement before opening new trades.
PYPL ranks No. 20 in its group and has a Composite Rating of 38, and EPS Rating of 83 and a Relative Strength Rating of 15.
This previous bear call spread example on Apple stock performed well and can be closed early for a nice profit.
Please remember that options are risky. 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.
