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Bearish Call Spread on SPY: How to set it up

In my last article, I mentioned a strategy for creating a core stock position by selling cash-secured puts on a stock until assigned, and then selling covered calls to generate income. I used (BAC) as an example, but that strategy applies to any stock.

In this article I will explain what a Bearish Call spread is, how to set up the trade and the possible scenarios you will face upon expiration Friday (the 3rd Friday of each month). I will use (SPY) as an example because it is representative of the stock market as a whole.

When should it be placed?

The Bearish Call Spread should be done when you expect:

  1. The stock to drift sideways during the trade.
  2. The stock not to exceed a certain level at expiration Friday.
  3. To use this trade as a hedge against your long positions.

What is it?

It is called "Bearish" because you do not expect the price of the underlying to go above a certain level.

It is a called call "spread" because you are trading the same number of calls on the same underlying security for the same expiration date, but you choose 2 different strike prices, selling the call that is closer to the current price, and buying a higher strike-price call.

The purchase of the higher strike call is critical to limit your loss in case the underlying security moved up in price in a violent fashion.

The trade

For this example, I will use a "135/140" bear call spread for August, using 10 option contracts (which represent 1,000 shares).

What this means is that we will "sell to open" 10 calls at strike price $135 for $2.86 credit per contract, and at the same time "buy to open" 10 calls at the strike price of $140 for $0.75 debit per contract. This will be placed for a $2.11 credit per contract. This is all done in the same order.

The difference between selling calls and selling call spreads is that selling call spreads allows you to set a range for your trades, setting specific levels of risk/reward.

I like to buy back call spreads when the price drops by 50% if I think the underlying will bounce up, or let the trade ride until the calls expire worthless, keeping the whole premium.

Placing this trade is essentially saying: "I think will not exceed the 135 level, or it will drop below it, by the 3rd Friday of August, which is August 17th".

You can set your levels depending on where you see being (or not being) in a certain time frame, just be sure not to go too far out in time (more than 6 months is not recommended).

The total income of this trade is $2,110 - commission; you are required to keep the remaining $2,890 in your account until the options expire. As you can see, (income) $2110+ (cash requirement) $2,890=$5,000, which is the $5 differential between the 135 strike price calls you sold and the 140 strike price calls you bought.

How the risk/reward looks like

The trade will look like this on expiration Friday, which is August 17th in this case:


(Click to enlarge)

The picture above describes your profit or loss on August 17th. Notice how your maximum loss is the amount of cash you need to keep in your account in case is at or above the 140 strike price by expiration. Your maximum profit will be the $2,110 you received when you placed this trade if closes at or below 135 on August 17th, representing a 42.2% ROI.

The break-even point for this trade is 137.11. This means that can be at this level on August 17th and you will still not lose money. This is because of the $2.11 credit you received while placing this trade ($135+$2.11=$137.11).

4 scenarios can play out at expiration Friday:

  1. is below $135
  2. is at or below $137.11 (the break-even point), but above $135
  1. is at or above $137.11 but below $140.
  2. is above $140.

The first case is the ideal scenario, you would keep the whole premium if is at or below $135, letting both the calls you sold and the calls you bought expire worthless, as anyone who bought those calls from you would prefer to buy stock or calls on the market.

In the second case, you can either close your trade a week before expiration for a small loss, or wait to see in which direction does move; this depends on your risk tolerance, if you keep this trade open and is flirting with the line between losses and profits on expiration week, expect a lot of adrenaline, and be sure to close it if moves up.

In the third scenario, you would incur in a loss, how large the loss is depends on when you close the trade. I recommend closing this trade at least 7 to 5 days prior to expiration, because at that point, time is against you.

Time (theta decay) plays in your favor if is below 137.11, but if the market moves against your trade and your position is still open during expiration week, it will be very costly to "buy to close" your trade.

Hoping price will go down in less than 5 days is not trading, it is gambling, I have been there, and trust me, it is not a good spot to be in.

The fourth scenario will be discussed below.

Closing the trade

So imagine today it is August 9th and you see around 139 and only going higher, what to do?

You need to close this trade for a loss before it becomes bigger. To close this trade, you need to "buy to close" the 10 calls you sold, and at the same time, "sell to close" the 10 calls you bought.

Knowing when to close the trade is a big part of trading, and it can be the difference between paying $3.50 per contract for closing it (incurring in a $1.39 loss per contract) or the full "spread", $5 per contract, incurring in the full $2.89 loss per contract if you keep the position open until expiration Friday.


(Click to enlarge)

If on August 9th crosses above the yellow line (137.11), I advise to close that position, you should immediately close it as it approaches the red line, and feel free to either close your position to secure profits if below the white line, or ride it out if you think will not be above 135 the next week, which is expiration Friday.

Why use 5 point strike differentials?

You can play with the strike prices anyway you like, tightening or loosening your strike prices.

For example, you could sell 50 calls for $135 for August and buy 50 calls for August for a $0.53 credit per contract, or $53 per contract. Maximum loss would be $0.47, or $47 per contract.

This would seem like a better trade to some because of the higher ROI, but keep the following in mind:

  1. The break-even point for this trade would be lower: 135.53.
  2. Commissions will be higher, since you are trading a higher number of option contracts.


(Click to enlarge)

I would not recommend trading too tight of a call spread for the 2 reasons described above, as a 1.58 point difference in is significant, and the risk of losing $2,350 for an extra $540 is not worth it to me. Everybody has their style of trading; I prefer a bit of cushion in my trades in case my initial thesis was wrong.

Conclusion

This kind of trade can be done for every type of trader. Those who like to play it safe might choose to sell to open, for example, a 140/145 call spread, reducing their ROI to 13%, receiving only $0.65 per contract and risking a maximum of $4.35, but having a break-even point of $140.65. The probability of being above $140.65 is a lot lower than the original example.

More aggressive traders might trade tighter and closer to the current stock price, leaving them with more ROI if successful, but less room for error.

Feel free to choose your underlying, strike prices and month.

Always lay out your plan before you trade, choosing a "maximum pain" threshold, where you would close your trade if the loss exceeds "x" amount of dollars at any time. The first bear call spread I had years ago had no real plan, I just held my position at a loss until I had to close the trade by buying to close at the maximum price, I remember it was $5 per spread, because I hoped the stock would reverse.

That was a terrible mistake. The trade was on (GOOG). Always remember that equities tend to move more than the general market, so I would recommend this strategy for more than for equities in general. Paper trade first to get a feel for this strategy.

If you have any comments or questions, feel free to use the section below.

Source: Bearish Call Spread On The S&P 500 ETF: How To Set It Up