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CL: Brushing Up on a Defensive Play

Jill and Scott review the fundamentals and technicals in the consumer staples space and call out a trade in Colgate-Palmolive (CL - Get Report) in the video below.



Here is a smartly structured options trade for a trader who is looking to for strength in a declining market.

This year CL has outperformed the S&P 500. It's had its ups and downs just like the rest, but it's strong. If the market continues lower, CL might not rise sharply -- in fact, it probably won't. But it is likely to "hang in there" and either enjoy modest gains, stay stable, or at least not suffer as badly as the broad market.

But right now CL's options are priced with a classic built-in fear premium that often accompanies falling markets running amok with fear mongers. This fear premium can be observed by studying CL options' implied volatility.

Right now, CL's implied volatility is high. The 30-day implied volatility is sitting up around 20%, which is in the top third of the six-month range. Further, the implied volatility is decidedly above the 30-day historical volatility, which is around 14%. What's all this mean? CL options are expensive.

The objectives of this trade set up will be two fold:

Volatility objective: To structure a trade that benefits from over-priced options (or at least doesn't suffer from because of it)

Directional objective(s): To profit if CL shares rise (though there is no expectation for a big rise, and thus it is acceptable to forgo profits if an upside breakout should occur), if they remain steady, or even if they slightly decline in value.

Given this thesis, a logical trade set up would be to sell an out-of-the-money put credit spread.

The next step in this trade set up is going to the option chain to see A) whether such a trade can be structured well given current available strikes and put prices, and B) which specific strikes and months make the most sense.

In this case, the best choice is to sell the CL August 80/82.5 put spread at $0.40 by executing the following legs:

Trades: Sell to open CL August 82.5 puts at $0.74 and buy to open CL August 80 puts for $0.34 for a net credit of $0.40.

Why this particular spread? The 80/82.5 spread is the lowest strikes to sell while still getting some "meat" for options premium. The short strike is the price point the underlying must remain above to deliver the maximum profit. The lower the short strike, the better because it provides more room for being wrong. But the 77.5/80 spread is only $0.09 bid. There's not enough premium there to make the trade worthwhile.

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