As we all know, oil prices have sky-rocketed this year. And some of the beneficiaries, of course, have been the major oil players, namely Exxon Mobil (XOM).
In fact, the oil behemoth has pushed over 40% higher this year, while many stocks have suffered mightily. And my goal is to keep some of those gains. In the past I’ve talked about collars as a way to cap gains while limiting my downside, but today I want to discuss another hedge-based strategy, the bear call spread.
As you can see in the chart below XOM is currently trading for 82.18. I want to sell a bear call spread with at least an 80% probability of success. This should give me some a nice margin of error just in case XOM pushes past near-term highs.
Again, I want to place a short-term bear call spread going out 25 days. My intent is to take off the trade well before the May 20, 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.
The Trade – Bear Call Spread Example
Once we choose our expiration cycle (it will differ in duration depending on outlook and strategy), we begin the process of looking for a call strike within the May 20, 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 0.20, as seen below.
Next, I want to know what the expected move or expected range is for XOM during the May 20, 2022, expiration cycle. The range is currently from 89 to 73.
Since we are focused on using a bearish spread example, we only care about the upside risk at the moment.
By knowing that the market anticipates XOM going as high as 89 by May expiration in 25 days, it allows us to choose a short call strike around that number. This will define our probability of success on the trade.
The 89 call strike, with an 82.34% probability of success, works. It’s right at the high side of the expected range, and we can adjust accordingly if needed. I want to have an opportunity to bring in around 10% to 15%, while keeping my probability of success around 80%.
The short 89 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 XOM stays below the 89 call strike at the May 20 expiration in 25 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.
Also, time decay works in our favor on the trade, so as we get closer and 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, XOM spikes to the upside over the next 25 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 89 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 max risk and my premium increase as my chosen spread width increases.
Bearish Spread Example: XOM May 20, 2022, 89/94 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open XOM May 20, 2022, 89 strike call.
Buy to open XOM May 20, 2022, 94 strike call for a total net credit of roughly $0.55 or $55 per bear call spread.
- Probability of Success: 82.34%
- Total net credit: $0.55, or $55 per bear call spread
- Total risk per spread: $4.45 or $445 per bear call spread
- Max Potential Return: 12.4%
As long as XOM stays below our 89 strike at expiration in 25 days, I have the potential to make a max profit of 12.4 % 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 $0.55, I would look to buy it back when the price of my spread hits roughly $0.25 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, 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.
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 2 to 3 times my original credit. Since I’m selling the 89/94 bear call spread for $0.55, if my bear call spread reaches approximately $1.10 to $1.65, I will exit the trade.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Newsletter for education, research and trade ideas.