Here is a trade that I took and at the time it looked very promising and thought nothing could go wrong. But it actually did. It went against me. But instead of loosing money I actually turned the trade into profit and made more money than what I meant to be making when I took the trade initially.
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 known 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
HES prices were resisting as shown by the red line in the chart, on Monday 28 November 2016 prices strongly went down. On Tuesday 29 November, prices gapped down and followed through the down movement and that’s when I decided to take the trade.
| Side | Quantity | Symbol | Expiration date | Strike price | Type |
| SELL | 10 | HES | 03 DEC 16 | 54.00 | CALL |
| BUY | 10 | HES | 03 DEC 16 | 56.50 | CALL |
Capital requirement to do this trade was $1500 and have received $0.10 credit per share. If successful with the trade, I would make $78.05 net profit, that’s 5.20% return on the capital invested in 4 days. Below is the calculation.
| Capital requirement/maximum loss | $1500.00 | 10 contracts, each options contract consist of 100 shares, $1.50 spread between strike prices (10 x 100 x $1.50 = $1500). |
| Projected Net profit | $78.05 | ($0.10 x 100 x 10 – $21.95 commission = $78.05 |
Managing the trade
But unfortunately with some big news on the oil, prices gapped up the next day and started moving up strongly. As soon as it hits the resistance level (shown by the red line) I ‘bought back the call option I sold’ and waited prices to move even higher so that I can ‘sell the call option that I bought’ when initially took the trade. This process is called ‘legging out’ or ‘breaking the leg’. This actually made me more profit. Calculations are shown below.
| Bear Call Spread | |||||||
| Side | Strike price | Quantity | share/contract | Credit/Debit | Amount | Commission | Total |
| Sell | 56.5 | 10 | 100 | 1.30 (credit) | 1300 | 21.95 | 1278.05 |
| Buy back | 54 | 10 | 100 | 1.10 (debit) | 1100 | 21.95 | 1121.95 |
| Profit | 156.10 | ||||||
When it crossed the resistance level I decided to break the leg and bought back 54 call option at $1.10 per share. Followed the stock going up and put an order to sell the 56.50 call at $1.30. I saw the stock going up and hit the strike price and was ITM, I stuck to my original plan to get out at $1.30. I could have possibly made more money if I hold on to it for little longer or till the next day.
Received $78.05 initially when took the trade and made another $156.10 managing the trade that equals to $234.15 profit. That’s 15.61% profit of the original capital invested.