Yesterday's reversal in the indexes was impressive. But it's still a market in correction. That means it's still worth looking at bearish option strategies. Here's a look at setting up a bear call spread in PayPal stock.
PayPal Stock Started Its Bear Market Early
PayPal started a nasty downtrend back in July. Though it closed off its lows yesterday, unlike many other stocks, it wasn't able to finish in the green.
The rankings on PayPal stock are pretty dismal. It's ranked No. 2 in its group and has a Composite Rating of 39, a decent EPS Rating of 83 and a Relative Strength Rating of 15.
For the bear call spread, we sell an out-of-the-money call and buy a further out-of-the-money call. The strategy can profit if the stock trades lower, sideways, and even if it trades slightly higher. The key is for PayPal stock to finish below the short call strike at expiry.
Setting Up The Bear Call Spread
Using a February expiry, this bear call spread uses the 170 strike as the short call and the 175 strike as the long call. Yesterday, that spread was trading for around $1.75.
If executed at that price, the maximum profit on the trade would be $175 per contract, the premium you received as a credit. The maximum risk is $325. That the difference between the strikes less the premium received.
This bear call spread achieves the maximum profit if PYPL stock closes below 170 on Feb. 18. Should that happen, the entire spread expires worthless. The trader keep the entire $175 option premium. That's about a 54% return on risk in just under a month.
The maximum loss occurs if PayPal closes above 175 on Feb. 18. If held until expiration, the premium seller loses $325 on the trade.
Managing The Trade
What's nice about the bear call spread is it's a risk-defined trade. You always know the worst-case scenario in advance. If PayPal stock jumps up way above 175, the long call offers protection and your loss is capped at $325.
That doesn't mean you need to take the full loss. A stop loss could be set if PYPL stock trades above 170, or if the spread value rises from $1.75 to $3.50.
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 minutes before opening new trades.
Also, keep in mind, you can take profits early. This previous bear call spread example on Apple stock performed well. Rather than holding until and can be closed early for a nice profit.
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 Twitter at @OptiontradinIQ
