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Dow Jones Component 3M Stock Could Add Bearish Exposure With Options

With the Dow Jones Industrial Average pulling back to its 50-day line, traders may be looking to add some bearish exposure to their portfolios. Take 3M (MMM). It took a big hit yesterday, falling below its 200-day moving average line. Here’s a bear call spread on 3M stock that benefits as long as the price stays near these levels or lower.




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Dow Jones Weakens But 3M Stock Is Even Weaker

Among Dow Jones industrials members, 3M stock is on the weaker side. It led the downside for the Dow Jones yesterday with a 4.5% drop. Plus, 3M stock is one of just a few Dow Jones components trading below its 200-day moving average line.

It’s a weak stock in a weak industry group. The diversified operations group stands at 107 out of the 197 industry groups. 3M stock is in the lower half of the group at No. 13.

The ratings for 3M stock are also mediocre. The IBD Composite Rating stands at 64, the EPS Rating at 74 and the Relative Strength Rating a paltry 36. Not the makings of a star performer.

So how can you profit on a weak stock? Setting up a bear call spread can be profitable if 3M stock trades lower, sideways, and even if it trades slightly higher. Here’s how it works.

Bear Call Spread Setup

A bear call spread involves selling an out-of-the-money call and buying a further out-of-the-money call. The long call at the higher strike price acts as your protection should the trade work against you.

For 3M stock, an Oct. 15 expiration on a bear call spread could use the 195 strike on the short call and the 200 strike as the long call. Yesterday, that spread traded for around 75 cents per share and today it’s around 92 cents.

The option trader receives that premium and should the options expire worthless (which is what you want in this case) you keep the premium. A close below the short strike of 195 on Oct. 15 achieves the maximum profit.

What about the risk on this Dow Jones stock? The maximum risk is calculated as the difference of the strikes less the premium received. If you took in $92 of premium, the most you can lose is $408. That occurs if 3M stock closes above 200 at expiry.

Overall, that gives this bear call spread a 23% return on risk in just over a month’s time.

If you liked the trade yesterday, you may like it even more today. The gain in 3M stock today gives you a larger credit than yesterday. Given yesterday’s drop, it’s a pretty weak bounce. Still, it improves the profit potential and lowers the risk.

Defined-Risk Strategy

Just having the short call, an option trader is open to the risk of unlimited losses. After all, there is no telling how high a stock can go. But the bear call spread is a defined-risk strategy.

If 3M stock skyrockets, the long call at 200 kicks in and offsets the losses from the short call. That way, you always know the worst-case scenario in advance.

Another benefit of this option strategy is that it profits in multiple ways. A move lower or sideways for 3M stock will lead to the calls expiring worthless. Even a 4% jump from here would keep the trade at maximum profit, as long as 3M stock closes below 195 by the expiration.

As this is a bearish position, traders that think 3M stock will continue moving higher from here should not enter this trade.

Earnings for 3M stock are scheduled for late October, so there should be no earnings risk with this trade.

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.

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