Trading the McSKEW

From  its  early  2012 high until October of 2015 McDonald’s (MCD) stock remained basically flat. In that same period the S&P 500 gained roughly 50%. MCD was clearly languishing. There was talk that MCD’s star had faded (see “Breakfast rally,” below). 

In October of 2015, MCD began serving breakfast all day. MCD then had a breakout during the next eight months, closing at $131.60 on May 10, 2016. MCD was obviously out of its rut. By Oct. 20, 2016 MCD corrected to $110.57, and has been a moonshot ever since, closing at $156.58 on July 12, 2017. That’s a 41% gain in less than 10 months. 

What should a trader who’s still bullish but afraid of a near term correction do? Let’s say that you have $35,000 to work with and you want to participate in further upward moves. You could buy 200 shares at $156.58 per share. That’s a commitment of $31,316. If you were to margin the purchase with Reg-T you could buy double the number of shares. If MCD started moving down you would have to throw additional money into the trade because you are using margin. That might force you to sell 100 of the 400 shares. Also, since MCD recently ran up 41% you could be looking at a violent retracement with no shock absorbers available.

If you are looking to define your risk you can establish an options position. The first things you look at when establishing an options position are the liquidity of the options traded, the options skew, the earnings date and the ex-dividend date. 

While the liquidity in the options for MCD is not as good as SPY, GLD or the FANG (Facebook, Apple, Netflix, Google) stocks, it is still adequate. The next thing to look at is the options skew. With MCD trading at $156.58 you can look at August options that expire on Aug. 18. 

The August 170 calls are trading at 20¢ while the Aug 145 puts are trading at 57¢. This is odd in that the 145 strike price is $11.58 away from the current price and the 170 strike price is $13.42 away from the current price. The difference in the proximity to the strike price still does not account for the nearly 3:1 difference in premiums. The difference in the premiums tells you a story. This does not mean that traders believe that MCD is more likely to go down than go up. What it does mean is that historically, when MCD goes down it happens much more quickly than when it goes up. In other words, it might take two months to get to 170, but it might take two days to get to 145. MCD is positively skewed to the downside and negatively skewed to the upside. 

You can buy 20 of the August 160 calls at $1.90, which gives you 10 times the leverage of buying 200 shares of stock. It would cost you $3,800 as opposed to $31,316. You have defined your risk at $3,800. The breakeven point for the trade would be $161.90 while the stock purchase would be in-the-money with any upward move. You can lower your breakeven point and your maximum possible loss by selling 20 of the August 165 calls at 64¢. The new breakeven point would be $161.26, while your new max loss would be lowered to $2,520.

Instead of having unlimited upside profits your new max profit would be $7,480. If you take into account the skew, then you can look at selling double the number of Aug 165 calls, creating a 1x2 call ratio spread. Because MCD moves slowly to the upside you would be able reel in some of your short calls before the risk was too great as Theta will work in your favor even as the market approached your short call strike. Your new downside risk would be lowered to $1,240. 

When trading off of the skew beware of news, an earnings release can cause a gap move in either direction regardless of the skew.