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Options Corner: Bear Call Spread on John Deere

|Includes: Deere & Company (DE)
The Play: John Deere (NYSE:DE)

John Deere had a strong July showing signs of an increase in demand for construction equipment and possible signs of an improving economy. However, investors could have gotten a little too excited about the outlook on the overall economy and expansion in the construction industry. John Deere’s stock has increased over 20% since July 1st and these last few days it has shown signs of topping out.

Although the stock has done well lately, the likelihood of DE increasing another 10% over the next 6 weeks is low. August has traditionally been a boring month for the overall market due to the fact earnings are coming to end and many traders are trying to get in that last summer vacation before the kids go back to school. I’ve tracked cumulative daily changes on a monthly basis for John Deere back to 1990 and as you can see below September is the worst performing month for John Deere going back 20 years.

DE Average Return per Month for the last 20 years

This makes for a great OTM Bear Call Spread opportunity. To take advantage of DE rapid increase and historically weak September performance you can sell call options at the 72.5 strike price and buy call options at the 75 strike price. A nice tight vertical spread like this can reduce your overall risk.

On Tuesday DE stock prices closed out at $66.82, which was a pull back from its two year high it had made on Monday. The $72.50 call options are 8.50% above the current stock price and you will be receiving a premium of $0.95. The $75 call options will cost you $0.45 giving you an overall credit for the trade of $0.50.

Assuming you buy 5 contracts at the $75 strike and sell 5 contracts at the $72.50 your margin requirement will be $1,250, with a maximum profit of $250 ($0.50 x 500) if held to expiration and DE stays below your breakeven point of $73. This would give you a 20% return on your investment in just over 6 weeks.

Your risk is limited to the $2.50 spread between your strikes of $72.50 and $75 minus (-) the $0.50 premium received as a credit, for a total of $1,000 total at risk with the 5 contracts.

To manage the trade effectively you will want to buy back the short call if the $72.50 strike is hit and let the $75 long call run to possibly make up for any losses taken on short call. 

All this is based on the research that September is the worst performing month on average for John Deere (DE) over the last twenty years and bet against the stock making a 30% move from its July 1st lows in anything but ideal economic conditions.

The Strategy: OTM Bear Call Spread
The bear call spread strategy is a limited profit, limited risk option strategy that can be used when an options trader is slightly bearish on the underlying security. The vertical spread is constructed by buying call options at a certain strike price and selling the same number of call options at a lower strike price on the same underlying security with the same expiration month.

Parameters for Selling Bear Call Spreads
1.       Look for stocks that have had a big upward movement in a short period of time.
2.       Researching stocks at 10 day highs are a good place to start.
3.       Look for stocks that have enough volatility you will be reward with good premiums.
4.       The short call option should be at least 5% Out-of-Money from the stock’s current price.
5.       Keep the spread tight. Having a big spread between your long and short option calls increases your overall risk.

Click on this link to find out more details about other options strategies.

Disclosure: No positions