If you have the opinion that the market has hit a near-term high and isn't likely to move significantly higher over the next week you may want to consider a strategy known as a bear call spread. The bear call spread is a vertical spread. A bear call spread is also a credit spread. We'll receive an initial credit for opening the position then hope that the underlying stays flat or declines so both options expire worthless and we collect the maximum credit. With a bear call spread we sell the lower strike price call and buy the higher strike price call for a net credit. The higher strike price call serves as insurance and caps our maximum loss in the event the market makes a significant upside move.
The spread I have evaluated here is the weekly $140 Call/$142 Call spread that will expire on May 4. The SPY closed Friday, April 29th at $140.46. The $140 call is selling for $1.19 and the $142 call can be bought for $0.33 for a net credit of $0.86. For this particular spread we will want the SPY to decline over the next week. Our breakeven point at expiration will be $140.86, which is the net credit + the short strike price. If your opinion is that this rally will continue and that the S&P 500 will trend higher next week, this trade is not for you. If your market opinion is that the S&P 500 has topped out and will either stay flat or decline, this may be a suitable strategy. In the unlikely event that the SPY closes next week at exactly $140.46, the same as this week, you'll earning of 40 cents will equate to $1,720.
For the purpose of this evaluation, I set the maximum risk at $5,000. With a maximum risk tolerance of $5,000 we will sell 43 contracts. The actual worst case scenario if the S&P 500 is above $142 by next Friday would be a loss of $4,902. The theoretical profit is $2,021 and the maximum gain if the SPY is below $140 and both options expire worthless, at $3,698.
The delta of the $140 call is 0.57 and the delta of the $142 call is 0.24. Since the delta of the short call is greater than the delta of the long call and we have an equal number of contracts our net delta will be short and that means that we want the underlying to decline in value. The difference between the two thetas is two cents, so that means that will earn $86 a day just in time decay. Since you are short deltas and want the market to decline, in the event the market rises you can either close the position and take your loss or do some dynamic delta adjusting as the week goes on. Delta adjusting if the market rises and goes against you could consist of buying some calls, buying some of the underlying SPY, buying back some of the short calls, selling some puts or any combination of those. When adjustments are made you should consider all possibilities and make the adjustments that have the highest expected return. One of the elements that make option trading viable is the almost unlimited number of possibilities when initiating or adjusting a position. Your own creative thinking is the only real limit.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.