Bear Call Spread: The Perfect Trading Strategy?

We’ve witnessed an incredible move in the industrials over the past week or so.
On Sept. 29, the SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA), which tracks the Dow 30 stocks, closed the trading session at $160.23. As of the close on Oct. 8, DIA was 6.4% higher at $170.37. That’s an an average gain of almost 1% a day. A move that sharp over such a short time frame has led to an extreme overbought reading in DIA and several other major benchmark ETFs.
I don’t use the word “extreme” lightly. Oftentimes, partcularly in the world of trading, the word extreme is thrown around without context. As options sellers we need context; otherwise the information is useless. Again, that’s why I use the word “extreme” sparingly.

The above image shows the options chain for DIA at the close on Sept. 29, the day before the market’s recent surge. The highlighted area in blue shows the October 170 strike. More specifically, it shows the Prob. ITM, or the probability that DIA would reach $170 by Oct. 9.
In other words, as of the close on Sept. 29, there was a 3.55% probability that DIA would move roughly $10 higher and hit $170 by Oct. 9. As we all know by now, DIA hit $170 on Oct. 8.
We can also see the short-term extreme using my favorite mean-reversion indicator: RSI.
RSI, or relative strength index, was developed by technical analyst J. Welles Wilder Jr. It’s an overbought/oversold oscillator that compares the performance of an equity – in our case a highly liquid ETF – to itself over a period of time. It should not be confused with the term “relative strength,” which is the comparison of one entity’s performance to another.
Basically, the relative strength index allows us to gauge the probability of a short- to intermediate-term reversal. It does not tell us the exact entry or exit point, but it helps us to be aware that a reversal is on the horizon.

As an options trader, I love the aforementioned scenario.
Extreme, short-term, overbought readings – like what we are currently witnessing in DIA and many of the major indexes – oftentimes lead to a reversion to the mean over the short term.
“Reversion to the mean” simply means that there is a greater chance of a short-term reprieve or “fade” in the price of the underlying stock. I like to think of it as the perfect opportunity to sell premium.

The Strategy

So, given all the information stated so far, I’m obviously 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 bearish stance, given the extreme in mean reversion, by using an 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 me to keep the premium collected upfront.

The Trade

In this example, DIA is currently trading for $170.37 and is in an extreme overbought state.
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.

For example’s sake, I’ll choose the November 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 November 176 strike has a 79.44% probability of success. Essentially, by choosing the 176 strike, I am content with the 79.44% probability that DIA will not push from its current price of $170.37 to $176 over the next 43 days.
I could choose a more conservative strike – like the 177 strike with an 83.87% probability of success, or even the 178 strike with an 87.67% probability of success – but for this example, I am simply going with the strike closest to 80%.
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 176 – say, the 177 strike. Or, I can choose a strike that is further away from my short strike of 176 and pay less for the contract, thereby creating more premium in the trade.
I could sell the November 176 calls for roughly $0.90 and buy the November 178 calls for roughly $0.46. 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 the November 177 strike with a probability of success of 83.87%.

I will sell the November 177 strike for roughly $0.64 and simultaneously buy the November 179 strike for roughly $0.31. By doing so I will bring in a credit, or premium, of $0.33. The return on the trade is 19.7%.
Even though I am bringing in less premium, I have a larger margin of error on the trade. Essentially, as long as DIA stays below the 177 strike at expiration in 43 days I have the ability to reap a max return of 19.2%. 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 Thursday,  Oct. 15 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.

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