Historically, equity market volatility has created some of the best money making prospects for investors who are willing and able act on the opportunity. Merck & Co., Inc. (MRK) is an American large-cap pharmaceutical and animal health care stock. The stock has enjoyed an almost uninterrupted run over the past 4 years going from the low $30s in late 2011 to more than $63 earlier this year... all while paying a consistent dividend. However, like most health care and pharmaceutical stocks, Merck has experienced a notable price correction over the last few weeks. Here are three options strategies to capitalize on the stock’s recent volatility.
It’s important to note that Merck is expected to report 3rd quarter earnings on October 27th before the bell. Earnings announcements are almost always considered a potential price catalyst and options prices reflect this with higher than normal implied volatility.
PLAYING THE BEARISH TREND
The first strategy is to use options to speculate on a continuing bearish trend. There's a lot of technical evidence to support this strategy. After trading as high as $63 earlier this year, Merck is now changing hands below $50. In fact, it traded over $60 a share as recently as August 19th. From a technical standpoint, it's now below all of its significant moving averages and which are trending lower.
The aggressive approach would be to buy naked puts to maximize the options’ leverage benefit while risking the entire cost of the trade. The December $50 put option is selling for $2.44 and has an approximate delta of -53. Obviously, the break even price on this trade at expiration would be $47.56. A more conservative approach would be to use a combination of long stock and long put options. This approach provides relief in the event of a rally in the stock by owning shares while maintaining the majority of the leverage benefit in the options. For example, purchasing 150 shares of stock, 6 December $50 puts for $2.44 and 1 December $47.50 put for $1.35, the trade would have two break even prices… approximately $46.60 on the downside and approximately $60 on the upside. The trade would cost about $9,000 (before transactions fees) and have a maximum loss of about -$1,500. However, the trade still has exponential upside in the even that Merck’s stock falls below $46.60.
Before putting on any speculative options strategy, you should be cognizant of the stock’s technical factors. Currently Merck’s stock is displaying a large price variance to its 50 day moving average (approximately $53.40) which is a critical support and resistance level. Historically, it’s not usually this far away from that metric. This variance could lead to either an upward reversal to that resistance level or an extended holding pattern until the average catches up to the price before the stock makes its next move. Timing in speculative options trading is critical to long term success so technical factors must always be closely monitored.
It’s important to note that Merck is expected to report 3rd quarter earnings on October 27th before the bell. Earnings announcements are almost always considered a potential price catalyst and options prices reflect this with higher than normal implied volatility.
PLAYING THE BEARISH TREND
The first strategy is to use options to speculate on a continuing bearish trend. There's a lot of technical evidence to support this strategy. After trading as high as $63 earlier this year, Merck is now changing hands below $50. In fact, it traded over $60 a share as recently as August 19th. From a technical standpoint, it's now below all of its significant moving averages and which are trending lower.
The aggressive approach would be to buy naked puts to maximize the options’ leverage benefit while risking the entire cost of the trade. The December $50 put option is selling for $2.44 and has an approximate delta of -53. Obviously, the break even price on this trade at expiration would be $47.56. A more conservative approach would be to use a combination of long stock and long put options. This approach provides relief in the event of a rally in the stock by owning shares while maintaining the majority of the leverage benefit in the options. For example, purchasing 150 shares of stock, 6 December $50 puts for $2.44 and 1 December $47.50 put for $1.35, the trade would have two break even prices… approximately $46.60 on the downside and approximately $60 on the upside. The trade would cost about $9,000 (before transactions fees) and have a maximum loss of about -$1,500. However, the trade still has exponential upside in the even that Merck’s stock falls below $46.60.
Before putting on any speculative options strategy, you should be cognizant of the stock’s technical factors. Currently Merck’s stock is displaying a large price variance to its 50 day moving average (approximately $53.40) which is a critical support and resistance level. Historically, it’s not usually this far away from that metric. This variance could lead to either an upward reversal to that resistance level or an extended holding pattern until the average catches up to the price before the stock makes its next move. Timing in speculative options trading is critical to long term success so technical factors must always be closely monitored.
BUYING PROTECTION AGAINST CONTINUED FALLING PRICES
The second strategy involves using options as insurance to protect against further downside volatility. For investors who own Merck stock, the last 8 weeks haven’t been pleasant. To protect against a continued slide in the price of the stock, put options can be purchased to preserve capital.
This strategy involves substantively less risk than using options for price speculation but there are still multiple ways to approach it. The variations in execution lie along the surface of available contracts… shorter dated contracts will be cheaper than longer dated ones and out-of-the money contract will be cheaper than in-the-money contracts. Generally speaking, the cheaper the option, the greater the risk. For this example, only December options will be considered.
For an investor who owns 100 shares of Merck stock and wants a high level of protection, they would purchase an in-the-money option like the December $52.50 put for $4.10. This contract would limit losses to $125 but the stock price would have to exceed $53.70 before any profit could be realized. Conversely, an investor who also owns 100 shares of stock but wants a lower level of security could purchase the December $47.50 put for $1.35. In this scenario, the position would have a maximum loss of $350 but the stock would only have to exceed $51 a share to realize a profit.
The second strategy involves using options as insurance to protect against further downside volatility. For investors who own Merck stock, the last 8 weeks haven’t been pleasant. To protect against a continued slide in the price of the stock, put options can be purchased to preserve capital.
This strategy involves substantively less risk than using options for price speculation but there are still multiple ways to approach it. The variations in execution lie along the surface of available contracts… shorter dated contracts will be cheaper than longer dated ones and out-of-the money contract will be cheaper than in-the-money contracts. Generally speaking, the cheaper the option, the greater the risk. For this example, only December options will be considered.
For an investor who owns 100 shares of Merck stock and wants a high level of protection, they would purchase an in-the-money option like the December $52.50 put for $4.10. This contract would limit losses to $125 but the stock price would have to exceed $53.70 before any profit could be realized. Conversely, an investor who also owns 100 shares of stock but wants a lower level of security could purchase the December $47.50 put for $1.35. In this scenario, the position would have a maximum loss of $350 but the stock would only have to exceed $51 a share to realize a profit.
USING OPTIONS TO OPPORTUNISTICALLY ACQUIRE SHARES
The last strategy would be to use options to opportunistically buy shares of Merck stock in order to take advantage of the recent fall in price. Again, there are a couple of different ways of doing this each with varying amounts of risk. The conservative approach would simply be to buy a call option. With the price of the stock currently trading at $49.54, purchasing a single December $50 call option would give the contract holder the right to purchase 100 shares of the stock for $50 anytime between now and December 18th. This privilege would only cost $166 (December $50 call is $1.66 × 100 shares) and limit any losses to that amount should the price of the stock continue to fall. The more aggressive approach involves selling put options to effectively generate a discount to the purchase price of the stock. For example, if an investor sells 1 December $50 put for $2.34, she or he would collect a premium of $234 and is liable to purchase 100 shares of the stock for $50 regardless of the market price between now and expiration. This trade locks in a purchase price of $47.66… a tidy discount to the current market price. The risk in this approach can be drastically reduced by using a bull-put spread and buying a put cheaper option with the same expiration (offsetting a portion of the premium received) to cap losses should the price of the stock collapse.
The last strategy would be to use options to opportunistically buy shares of Merck stock in order to take advantage of the recent fall in price. Again, there are a couple of different ways of doing this each with varying amounts of risk. The conservative approach would simply be to buy a call option. With the price of the stock currently trading at $49.54, purchasing a single December $50 call option would give the contract holder the right to purchase 100 shares of the stock for $50 anytime between now and December 18th. This privilege would only cost $166 (December $50 call is $1.66 × 100 shares) and limit any losses to that amount should the price of the stock continue to fall. The more aggressive approach involves selling put options to effectively generate a discount to the purchase price of the stock. For example, if an investor sells 1 December $50 put for $2.34, she or he would collect a premium of $234 and is liable to purchase 100 shares of the stock for $50 regardless of the market price between now and expiration. This trade locks in a purchase price of $47.66… a tidy discount to the current market price. The risk in this approach can be drastically reduced by using a bull-put spread and buying a put cheaper option with the same expiration (offsetting a portion of the premium received) to cap losses should the price of the stock collapse.
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