Most investors are too busy fretting over the performance of their portfolios in 2022 to bother looking at potential investment opportunities, even though we’re in the midst of a volatility bull market.
We know, through all of the extreme negative sentiment seen across the board, that investors are wary of and in some cases fleeing the market.
The word “volatility” is being used among the financial talking heads in practically every conversation about the market. But those conversations are no longer limited to just the investment industry. Volatility has now become part of the lexicon among individual investors as well. In fact, when all is said and done, there is a good chance 2022 will go down as the year of volatility as roughly 25% of all trading days have seen a gain or loss of over 2%. And that means a volatility bull market.
How, as investors, can we take advantage of all this volatility? And how long will volatility last?
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It could be argued that even with a market that has seen lower prices for almost ten straight months, we could be in the early stages of a bull market in volatility. In baseball terms, we are in possibly the third to fourth inning. Since the pandemic hit the market back in early 2020, volatility has been significantly higher than the previous nine to 10 years, which marked one of the most complacent periods in market history, mostly due to bouts of quantitative easing and other forms of Fed relief.
Times have changed. But there’s a way to profit from the change…
A Volatility Bull Market Spells Opportunity
Volatility directly impacts options premium. As volatility increases, options premium increases, and vice versa. Simply stated, the price of options is currently inflated and has been for months.
The reason for the increase is simple: More and more investors, large and small, are buying protection, mostly through the use of puts. And with the increase in demand comes the increase in options prices.
As someone who predominantly uses options selling strategies, there is no better time to invest by using those same strategies, than right now.
Because the best way to take advantage of the inflated premium is to sell premium using a variety of options selling strategies.
I’m always puzzled why so many investors move to cash when the market turns sour, especially when there are risk-defined strategies to take advantage of a volatile and challenging market.
I mean, I get it. But oftentimes there are far better alternatives, especially if you know how to properly incorporate options strategies. And if not, well, it behooves us as self-directed investors to learn as much as we can about how to make money in all market environments, not just bullish ones. And that’s the beauty of options strategies—they allow us to make money regardless of the overall market trend. It’s all in the approach.
But again, a couple of questions come to mind: How can we take advantage of the inflated options pricing and what is an appropriate strategy to do so?
Well, there are numerous, risk-defined options strategies, all with weird names of course. Bull put spreads, iron condors and the strategy I want to discuss today, bear call spreads.
A bear call spread, otherwise known as a short call vertical spread, is one of my favorite risk-defined options strategies.
As the name of the strategy implies, a bear call spread is, well, a bearish-leaning strategy.
But it is important to note that the strategy doesn’t require the security to move lower to make money. Unlike the binary nature of stock strategies, a stock can either go up or down, with a bear call spread and you still have the opportunity to make money in either case.
A high-probability approach to the strategy gives you a built-in margin of error just in case the stock moves against you. And in this highly volatile environment, that margin of error is significantly greater than during a so-called “normal” market environment.
So again, with a bear call spread, you not only have the ability to make a return when a security moves lower, but you can also make money if the stock stays flat or even if the stock pushes slightly higher.
Let’s take a look at a quick example using a bear call spread with a high-probability approach. And when I say “high-probability approach,” I’m talking about a trade that has at least an 80% probability of success.
An SPY Bear Call Spread
With SPY trading for roughly 378, I want to look at a potential trade using a bear call spread, focusing more on the mechanics of the trade.
Below is the SPY options chain for the December 16, 2022, expiration cycle which has 39 days left until expiration.
The SPY 409 call strike, with an 86.57% probability of success, is where I want to start. By choosing the 409 call strike, not only is our probability of success well over 80%, our margin of error is roughly 31 points, or a cushion of 8.2%. Basically, SPY can move as high as 409 and we can still have the potential to make a profit on the trade. The short call strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Once I’ve chosen my short call strike, in this case the 409 call, I then proceed to look at a 3-strike-wide, 4-strike-wide and 5-strike-wide spread to buy.
The spread width of our bear call helps to define our risk on the trade. The smaller the width of the spread the less capital required. When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread width and my premium increase as my chosen spread width increases.
For our example, let’s take a look at the 5-strike, 409/414 bear call spread.
Trade Example: 409/414 Bear Call Spread
Simultaneously:
Sell to open SPY December 16, 2022, 409 strike
Buy to open SPY December 16, 2022, 414 strike for a total net credit of roughly $0.65 or $65 per bear call spread
- Probability of Success: 86.40%
- Total net credit: $0.65, or $65 per bear call spread
- Total risk per spread: $4.35, or $435 per bear call spread
- Max Potential Return: 14.9%
As long as SPY stays below our 409 strike at expiration, I have the potential to make 14.9% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration.
Risk Management
Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor…it also allows you to sleep well at night.
I also tend to set a stop-loss that sits 1 to 2 times my original credit. In my example, I sold the 409/414 bear call spread for $0.65. As a result, if my spread reaches $1.30 to $1.95 I will exit the trade.
As I’ve been writing about all year, we are getting more than three times as much premium per trade now, while our probabilities on each trade remain the same. Hence the volatility bull market. Thus, a trade with an 80% probability of success pays significantly more during volatile periods than that same 80% probability of success trade during normal times of volatility.
And that’s why now is the time to start selling options premium using risk-defined strategies! To find out how we’re taking advantage of these conditions with other trades, subscribe to a Cabot Options Institute advisory today.
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