Has the market rallied too far, too fast?
The Nasdaq 100 is up roughly 25% this year with nary a pullback, yet very few seem to be talking about the stellar performance. But what’s more incredible is that the first five months of 2023 have been the best for the tech sector in the last 20 years. That’s right, 20 years! And that’s a statistic that I haven’t heard mentioned by anyone in the financial media.
Unfortunately, the other indices haven’t really followed suit with tech’s start to 2023. The performance of the S&P 500, Dow Industrials and Russell 2000 are 7.9%, -0.22% and 1.1%, respectively.
So, the question begs, will the “others” close the gap with tech, or has the rally in tech gone too far, too fast?
I don’t know, but a bear call spread is a good way to take advantage of a slowdown in tech.
Ted Seides, CFA with 25 years as an institutional investor, started at the Yale University Investments Office working under the tutelage of famed investor David Swensen recently stated a pet peeve of his was “those who express absolutes in a world of probabilities.” He goes on to state, the late Peter Bernstein defined risk as “you don’t know what will happen,” adding “even when you think you do.” There’s a fine line that investors walk between conviction and humility, but those who believe they know the future without a shadow of a doubt fall a notch in my estimation.
I couldn’t agree more. No one has a crystal ball.
So, as investors we have to open up our toolbelt and use strategies that make sense given current market conditions. And when we do so, we don’t need to try to answer frivolous questions like, has the Nasdaq 100 gone too far, too fast. Because if tech, or any other sector or stock for that matter, begins to pull back, we will be prepared with a variety of strategies … much like we were one year ago when we started our Quant Trader service.
Over the past year, while the market has been tumultuous and challenging for investors, our Quant Trader strategies have a track record of 87.9% (29 out of 33 winning trades) for a total return of just under 150%.
Which leads me to why 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 strategies that are able to make returns in a variety of markets, bullish, bearish or sideways. 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.
Last year I wrote about the overall spike in options prices across the board due to the volatile nature of the market. In the article, I displayed a few images from my platform going over the difference in options prices during a “normal” market environment, compared to that of a highly volatile market like the one we’re in now.
But a couple 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.
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, 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.
A QQQ Bear Call Spread
With QQQ trading for 337.50, let’s take a look at a potential trade using a bear call spread, focusing more on the mechanics of the trade.
Below is the QQQ options chain for the July 21, 2023, expiration cycle with 57 days left until expiration.
The QQQ 363 call strike with an 86.30% probability of success is where I want to start. By choosing the 363 call strike, not only is our probability of success well over 80%, our margin of error is roughly 25.5 points, or 7.5%. Basically, QQQ can move as high as 363 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 363 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, 363/368 bear call spread.
Trade Example: 363/368 Bear Call Spread
Sell to open QQQ July 21, 2023, 363 strike
Buy to open QQQ July 21, 2023, 368 strike for a total net credit of roughly $0.70 or $70 per bear call spread
- Probability of Success: 86.30%
- Total net credit: $0.70, or $70 per bear call spread
- Total risk per spread: $4.30, or $430 per bear call spread
- Max Potential Return: 16.3% over 57 days
As long as QQQ stays below our 363 call strike at expiration, I have the potential to make 16.3% 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. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit.
Since we sold the spread for $0.70, I want to buy it back when the price of my spread hits roughly $0.35 to $0.15. Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.
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 363/368 bear call spread for $0.70. As a result, if my spread reaches $1.40 to $2.10 I will exit the trade.
Again, to reiterate, by using a combination of bear call spreads, bull put spreads and iron condors we have managed to win 29 out of 33 winning trades since starting our Quant Trader service.
And that’s why now is the time to start selling options premium using risk-defined strategies.
Now, if you need help doing it, and want to learn about some of my other options selling strategies, on June 8, 2023 at 2:00 PM ET, I will be discussing all things Quant Trader including a detailed look at each strategy, risk-management techniques and much more…including a LIVE Trade.
To learn more about it, and to decide if Quant Trader might be right for you – simply click here to register for the free webinar.