Bear Call (Credit) Spread – SPX

Strategy – Bear Call 

The strategy involves selling an Out of the Money Call Option of an underlying stock and buying further out (most often the next strike price) less expensive Out of the Money Call Option for protection. These selling and buying different strike price call options creates a credit and that’s the maximum profit for the trade if successful. Maximum loss will be the difference between sold and bought call option strike prices.

Reasoning

Expecting prices to pull back of an underlying stock for next few days and you are taking advantage of this. You are promising to deliver to a buyer a stock at a specific price and by a specified date as per the contract hoping that you don’t have keep that promise. You charge a small amount money know as premium for this promise. Think of your health insurance. You pay a small amount of premium every month to the insurance provider hoping to cover for all expenses in case you get sick.  Whereas the Insurance provider hopes that you don’t get sick and they keep the premium as profit. The amount of premium totally depends upon the level of risk.

Idea of buying a further out call option is basically ‘you buying a promise from someone else’ to have the stock delivered in case you need it. Two main reasons to do this are – a) reduce your loss in case the trade doesn’t go as per your prediction b) reduce the capital requirement to do the trade. Capital requirement will be the difference between strike prices multi-plied by number of contracts.

Outlook and Action

SPX (S & P 500 Index) traded outside the Bollinger Band (purple line in the chart) 01 & 02 June 17 and on 02 June it closed at $2439.07. Once this happens, general tendency is that prices come back inside the Bollinger Band fairly quickly and stays inside for next few days. And that’s what happened in this scenario. Prices came back inside the Bollinger Band in the next trading day on 05 June 17 and traded in small price range. Between 02 & 05 June it formed a “Bearish Harami” candlestick pattern, it’s another signal that prices will have a short time pull back. On Tuesday 06 June, a sell signal day flashed with the technical indicator I use to determine if I would be taking any trade or not with a particular stock. On Wednesday I was waiting for prices to follow through the signal day (meaning prices going down as expected) and as it did during first half of the trading day, I took the trade. Prices bounced back up later during the day though. It was weekly options, expiring Friday 09 June 17, strike prices sold and bought were outside the Bollinger band and the probability of being OTM was above 94% when took the trade. Meaning chances of prices hitting the sold call option was only 6%. That’s amazing, isn’t it? When taking the trade, you already know that there is 94% chance that the trade is going to be successful.

Capital requirement to do this trade was $5000 and have received $0.25 credit per share. If successful with the trade and as it did, made $228.05 net profit, that’s 4.56% return on the capital invested in 3 days. Below is the calculation.

Red flag

All indices are on up trend, SPX is making all time highs pretty much every week since it broke through the resistance level on the upside on 25 May 17. So, there was bit of a risk with this trade. And as soon as I took the trade, mentally I was ready to manage it in case it goes bad. However, have noticed a divergence between prices and MACD (Moving Average Convergence Divergence – a trend following momentum indicator) on 27 April and 02 June and that gave the confidence that the upside momentum is slowing down and possibilities of a pull back is strong.

P.S Please note that the trade is now closed. Do not copy and place a trade unless you are an expert and know what you are doing.  This writing is only for educational purposes. Trading is risky without proper knowledge, practice, expertise and mentorship.