Each week I send out my High-Probability Mean Reversion Indicator which includes roughly 25-35 highly liquid ETFs. In the next few months, I’ll be doing the same with a highly liquid list of stocks as well.
The list contains the overbought/oversold levels of each ETF as well as the current implied volatility and IV rank. And at the moment, we have quite a few ETFs that are considered overbought. Currently, one of the most overbought ETFs is the VanEck Semiconductor ETF (SMH).
The semiconductor has pushed into a short-term overbought extreme. Typically, when this type of short-term extreme is hit a short-term reprieve is right around the corner.
As I’ve explained in the past, there are numerous strategies that we can use when a highly liquid ETF hits an overbought state, but my favorite is a bear call spread.
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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. So, 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.
Short-Term Overbought State in SMH
With SMH now trading for roughly 232 I want to place a short-term bear call spread going out around 30-50 days.
My intent is to take off the trade well before the September 2, 2022, expiration date. For this bearish spread example, my preference is to go with a trade that has around an 80% to 85% probability of success.
As always, let’s start by taking a look at the various expiration cycles for SMH going out around 30-50 days until expiration.
Once we choose our expiration cycle (it will differ in duration depending on outlook, strategy and risk), we begin the process of looking for a call strike within the September 2, 2022, expiration cycle that has around an 80% probability of success.
If you don’t have access to probabilities of success on your trading platform look towards the delta. Without going into too much detail, look for a call strike that has a delta around 0.15 to 0.20, as seen below.
Since we are focused on using a bear call spread, we only care about the upside risk at the moment.
The 255 call strike, with an 82.08% probability of success, works. It’s just outside the expected range, but we can adjust accordingly if needed. I want to have an opportunity to bring in 22% over the next 42 days, while keeping my probability of success at the onset of the trade to around 80% or higher.
The short 255 call strike defines my probability of success on the trade. It also helps to define my overall premium, or return, on the trade. Basically, as long as SMH stays below the 255 call strike at the September expiration in 42 days we will make a max profit on the trade. But, as I stated before, my preference is to take off profits early and, in most cases, reestablish a position if warranted, much like I have over the past several months.
Also, time decay works in our favor on the trade, so as we get closer to expiration our premium will erode at an accelerated rate. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration–unless, of course, SMH spikes to the upside over the next 42 days. But still, that doesn’t hide the fact that with this trade we can be completely wrong in our directional assumption and still make a max profit.
Once I’ve chosen my short call strike, in this case the 255 call, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide spread to buy.
The spread width of our bear call defines our risk/capital on the trade.
The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread.
When defining your position size, knowing the overall defined risk per trade is essential. Basically, my premium increases as my chosen spread width increases.
Bear Call Spread: September 2, 2022, 255/260 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade if we so choose. Remember, this is more about learning the mechanics of how I approach a bear call spread when a stock has reached an overbought state.
Simultaneously:
Sell to open SMH September 2, 2022, 255 strike call.
Buy to open SMH September 2, 2022, 260 strike call for a total net credit of roughly $0.90, or $90 per bear call spread.
- Probability of Success: 82.08%
- Total net credit: $0.90, or $90 per bear call spread
- Total risk per spread: $4.10, or $410 per bear call spread
- Max Potential Return: 22.0%
Again, as long as SMH stays below our 255 strike at expiration in 42 days, I have the potential to make a max profit of 22% on the trade. In most cases, I will make less, as the prudent move is to buy back the bear call spread prior to expiration.
Again, I look to buy back a spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.90, I would look to buy it back when the price of my spread hits roughly $0.45 to $0.30, if not less.
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, or at least half the risk, by locking in profits is never a bad decision, and by doing so we can take advantage of other opportunities the market has to offer.
Risk Management
Since we know how much we stand to make and lose prior to order entry we can precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so 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. Since I’m selling the 255/260 bear call spread for $0.90, if my bear call spread reaches approximately $1.80 to $2.70, I will exit the trade.
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