Today's price action had the bears extremely excited for most of the day. While most experienced traders expected some support at the 1400 level, I am not sure that anyone was expecting the bounce that we witnessed during the latter part of the day.
I am still somewhat bearish. My thought is that we will eventually see the two SPY gaps (11/19 and 11/29) from November close over the coming month. But as we all know, there are no guarantees. No one holds the holy grail to trading.
Which is why I always make trades with a margin for error. Credit spreads allow me this benefit... and since I have a short-term bearish view, a bear call spread is my strategy of choice.
What Is A Bear Call Spread?
A bear call spread is a credit spread composed of a short call at a lower strike and a long call at a higher strike. The nature of call pricing structure tells us that the higher strike call we are buying will cost less than the money collected from the sale of a lower strike call. It is for this reason that this spread involves a cash inflow or credit to the trader/investor.
The ideal condition is for the spread to expire worthless, thus allowing you to keep the premium collected at the time of the sale of the spread. In order for this to happen, the underlying will have to close below the lower strike call option that you are short.
The basic premise of the strategy is easy: you choose the probability of the trade. Increasing the probability of success will decrease your potential profits, but will increase your likelihood of success.
Here is an example of how I might use a bear call spread in today's market. So, with SPY surging 8.2% and into an overbought state, SPY was well overdue for a pullback, at least temporarily. Again, now that I have an assumption in place, let's move onto my strategy of choice… the bear call spread.
With SPY trading at $141.50, I want to choose a short strike for my bear call spread that met my risk/return objectives. I prefer a win rate/probability of success in the 75%-95% range. As such, I chose the Feb13 149/151 bear call spread. I like to give myself a decent margin for error, which obviously increases my probability of success. For example, the 149 strike allows for a $7.50 or 5.3% cushion to the upside.
The Feb13 SPY 149/151 bear call spread met my expectations, as it brought in a credit of approximately $.28 or $28 per contract. As a result:
- The max gain on the trade - 16.3%
- Probability of success - 83.8%
SPY would have to move above $149.28 for the trade to start losing value. As long as the stock price stays below $149.28 through February options expiration, the trade is successful.
Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably, the most powerful strategy in the professional options traders' tool belt. And I can use credit spreads as often as I like.
I trade credit spreads in both of my strategies. I will be officially opening up my strategies at the onset of 2013.
Disclosure: I am short IWM, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.