I’m sure a few of you have heard about the recent news of the so-called “death cross.”
Sounds scary, right?
For those unaware of this closely followed technical phenomenon, a death cross occurs when the S&P 500’s 50-day moving average falls below (crosses) the 200-day moving average.
Now I don’t really follow too many technical indicators. Probabilities are my preference. But, I found the following statistics on the death cross to be somewhat enlightening.
As stated by Dorsey, Wright and Associates, “The table below gives an overview of historic crosses and respective drawdowns. The drawdown column uses the closing value of the death cross initiation date for SPX and subtracts the lowest closing value for SPX over the timeframe until the 50-day moved back above the 200-day.”
Courtesy of Nasdaq.com
Basically, from 1950 to the present the average drawdown was -10.4%, with a max drawdown of -53.4%.
The question is how can we take advantage of this technical set-up?
My preference would be to sell vertical call spreads, otherwise known as bear call spreads. I’ve been doing this with great success over the past year and with the pop in implied volatility over the past few months, as seen through the VIX, now is a great time to sell premium. Of course, this doesn’t guarantee success, but with sound position-size, it might be worth taking a shot by using a high-probability approach.
With the S&P 500 (SPY) trading for 433.05 I want to place a short-term bear call spread going out 37 days. My intent is to take off the trade well before the April 22, 2022, expiration date. For this trade, my preference is to go with a trade that has around an 80% to 85% probability of success.
Let’s start by taking a look at the options chain for SPY with 37 days until expiration. 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 April 22, 2022, expiration cycle that has over 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 below 0.20.
The 454 call strike with an 80.49% probability of success works. It’s not outside of the expected range, but we can adjust accordingly if needed. I want to have an opportunity to bring in roughly 20%, while keeping my probability of success above 80%.
The short 454 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 SPY stays below the 454 call strike at the April 22, 2022 expiration in 37 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 SPY continues to spike to the upside over the next 37 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 454 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 spread-width and my premium increase as my chosen spread-width increases.
April 22, 2022, 454/459 Bear Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open SPY April 22, 2022, 454 strike call
Buy to open SPY April 22, 2022, 459 strike call for a total net credit of roughly $1.00 or $100 per bear call spread
- Probability of Success: 80.49%
- Total net credit: $1.00, or $100 per bear call spread
- Total risk per spread: $4.00, or $400 per bear call spread
- Max Potential Return: 25.0%
As long as SPY stays below our 454 strike at expiration in 37 days, I have the potential to make 25.0% 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. 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 $1.00, I would look to buy it back when the price of my spread hits roughly $0.50 to $0.25.
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 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. Since I’m selling the 454/459 bear call spread for $1.00, if my bear call spread reaches $2.00 to $3.00, 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.