Trade Google with Limited Risk

04/07/2011 8:00 am EST

Focus: OPTIONS

A well-planned ratio put spread on the tech giant can allow savvy traders to exploit significant profit potential while incurring little or no risk exposure unless the stock unexpectedly tanks.

Google, Inc. (GOOG) was off more than $20 at one point in Tuesday trading, but the stock recovered a bit later in the day to close down only $18 and change.

There was talk in the market of it being out of favor with the trading community. But what does the chart say and how can you profit from it?

The daily chart below shows the violent move down, but also that there looks to be more downside to come with support showing up at the bottom of the Bollinger bands and rising 200-day simple moving average (SMA) at $555.

chart
Click to Enlarge

This is also the low close on November 30, 2010 and support from mid March. The relative strength index (RSI) rejected off of the midline and has lots of downside room before being oversold, and the Moving Average Convergence Divergence (MACD) is fading, both supporting further downside.

On a measured move comparable to the move from $630 down to $555 over the February-to-March timeframe, the downside target is through the 50% Fibonacci at $520- $538. This is not far from the longer-term support/resistance line at $525, and there is also the 61.8% Fibonacci retracement at $513 nearby.

That is a lot of short potential, but it takes a lot of margin to short a $570 stock. You can get around that by using options to reduce the margin and risk in the trade while keeping a significant payoff potential.

Three strikes matched up with support levels on the chart pretty closely: $555, $535 and $525. By using these strikes to create a put spread, you can get paid a credit to have $20 potential return on a Google fall and have no risk exposure until it breaks $505.

The Trade

Buy 1 May 555 put
Sell 1 May 535 put
Sell 1 May 525 put

This is a ratio put spread in that you are long one put and short two lower-strike puts, and it technically gives you long exposure, but at a price below the lowest-strike put sold.

I put this trade on and was paid an 80-cent credit to do so, which was still available near the close. Prices will have changed by the time you read this, so be sure to calculate your own profit prior to executing a position.

The payoff graph below shows the maximum payoff of $20.80 occurs if Google closes between $525 and $535 on May expiry. From there it trails off to breakeven just under $505.

chart
Click to Enlarge

Any close under $525 would have the stock put to you, but by selling it immediately, you retain profits as long as the stock is above $505. If Google close above $555, then all the options expire worthless and you keep the credit of 80 cents.

The margin required for this trade at Interactive Brokers was $7,752 per spread, versus $9,313 to short 100 shares of stock, and the best part is that if it expires worthless, you get an 8.37% gross return on the margin over 45 days.

By Greg Harmon of DragonflyCap.com

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