Prepare Yourself for the Remainder of 2016 With This High-Probability Strategy

Last week, the seven-year bull market in the S&P 500 became the second-longest bull run for the major market index. The current bull market now trails only the decade-long mega-bull run in the 1990s that ended with the dot-com crash in 2000.
According to Bloomberg.com, at the close of trading Friday, the current bull market, which began on March 9, 2009, will have gone 2,608 calendar days without suffering a 20% loss on a closing basis, which is the official territory of a bear market. The longest bull market lasted 3,452 calendar days.

So, some would say this bull market has run its course. Well, maybe, no one knows for certain. But there are signs of bullish fatigue, with many of the companies that make up the S&P 500 nearing bearish territory and lots of evidence that the world economy is faltering, including some cracks in our own economy.
For instance, Bank of Japan Governor Haruhiko Kuroda’s announcement of negative interest rates in Japan, a failed attempt among 16 major petroleum producers to reach an agreement in Qatar, bad earnings from tech behemoths Apple (NASDAQ: AAPL), Alphabet (NASDAQ: GOOGL) and Microsoft (NASDAQ: MSFT), among others, are just a few bearish items that have pushed into the minds of the market. But again, none of this information has managed to push the market lower.
But in my opinion, the sentiment is about to change.
Furthermore, as I stated last week, the Wall Street adage “sell in May and go away” is once again upon us. And if history repeats itself we could be in for a rough summer.
So, given all the information stated so far, I’m obviously neutral to bearish, at least over the short term. I expect to see sideways-to-lower price action over the short term. But, I want to increase the odds of my stance by using a high-probability options strategy that allows me to have a margin of error just in case the short-term extremes continue.
In this case, a bear call spread – or vertical call spread – is the strategy of choice. It’s probably the most used strategy in my arsenal of options selling tools for a variety of reasons. Here are a few:

• I believe the market doesn’t crash higher; it crashes lower.
• The strategy allows me to have a margin of error just in case my directional assumptions are wrong.
• I can define my own risk/reward at order entry. Basically, I have the ability to choose my own probability of success on the trade. Of course, the higher the probability, the more I stand to lose. But again, I have the ability to define my risk, through proper position sizing, at order entry.

A vertical call is a credit spread composed of a short (sold) call at a lower strike price and a long (bought) call at a higher strike price. The nature of call pricing tells us that the higher-strike purchased call will cost less than the money collected from the lower-strike sold call. That’s why this spread involves a cash inflow, or credit.
The ideal outcome is for the underlying stock price to stay below the strike price of the sold call through option expiration. In this scenario, the spread expires worthless, allowing us to keep the premium collected upfront.

The Trade

In this example, SPY is currently trading for $207.45.

To start, I have to decide which of several expiration cycle to choose. I prefer to choose an expiration cycle with roughly 25-50 days left.

SPY Options Chain

For example’s sake, I’ll choose the June expiration cycle with 43 days left until expiration.
Once I decide which expiration cycle to use, I go straight to the probabilities.

I typically start with a short strike that has a probability of success around 80%. The short strike defines my trade. It tells me how much I am going to collect in premium, plus my probability of success on the trade.
The June 214 strike has an 80.18% probability of success. Essentially, by choosing the 214 strike, I am content with the 80.18% probability that SPY will not push from its current price of $207.45 to $214 over the next 43 days.
I could choose a more conservative strike – like the 215 strike with an 84.16% probability of success, or even the 216 strike with an 87.62% probability of success – but for this example, I am simply going with the strike closest to 80%. I will discuss how I choose strike prices in my upcoming webinar on Wednesday.
Next, I need to choose a strike to buy. This defines my risk. I can decrease my risk exposure by choosing a strike that is closer to my short strike of 214 – say, the 215 strike.

Or, I can choose a strike that is farther away from my short strike of 214 and pay less for the contract, thereby creating more premium in the trade.
I could sell the June 214 calls for roughly $0.96 and buy the June 216 calls for roughly $0.52. That equates to a credit of $0.44, or 28.2%.

After calculating the return, I decided the 28.2% was too high. I know it’s a strange way to look at investing, but it’s necessary to realize that a 28.2% return over 43 days comes with an associated risk. Nothing is free in the investing world. Don’t fool yourself. I am fine with a lower return, knowing I can increase my probability of success on the trade.
So, let’s move on to another scenario. What about selling the June 214.5 strike with a probability of success of 82.22% and buying the June 216.5 strike?

I can sell the June 214.5 strike for roughly $0.82 and simultaneously buy the June 216.5 strike for roughly $0.44. By doing so I will bring in a credit, or premium, of $0.38. The return on the trade is 23.5%.

Even though I am bringing in less premium, I have a larger margin of error on the trade. Essentially, as long as SPY stays below the 214.5 strike at expiration in 43 days, I have the ability to reap a max return of 23.5%. Realistically, it’s going to be slightly less, because I prefer to buy the spread back before expiration to lock in profits, take off risk and afford myself the opportunity to sell more premium.
Bear call spreads are not new to the world of investing. Unfortunately, not enough investors are aware of this sound options strategy which provides reasonable expectations for returns.
If you would like to know more about my vertical spreads trading strategy, please sign up for my free webinar on Wednesday, May 4 at 12 p.m. EDT. I’ll discuss, in detail, several credit spread strategies in a real-time environment, plus field all of your options-related questions in an extended Q-and-A session.
If you can’t make it, no worries, just sign up and I will send you a replay shortly after the event.