Here we go again!
A few weeks ago, I posted a bear call spread on the S&P 500 (SPY). At the time SPY was trading for $454.97. Now SPY is back under $440, and our bear call spread is worth well-less than half of our original premium. As a result, our profit target was met.
As I state in every “Trade Idea” post, “I look to buy back a spread when I can lock in 50% to 75% of the original credit.”
Since we sold the 479/484 bear call spread for $0.67, I would buy it back when the price of my spread hits roughly $0.35 to roughly $0.17, if not less. Target met. It’s currently trading for $0.15. As a result, we can lock in profits of 11.6%. Not bad for a short-term high-probability trade. And another reminder to stick to the guidelines and not try to squeeze every last penny out of a spread.
Again, stick to the mechanics. There is a reason why they exist and why I state them in every trade idea. Profit taking is a form of risk management!
New Trade Idea
SPY now trading for 436.55 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 March 18, 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 SPY 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 March 18, 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 .15 to .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 465 call strike, with an 88.29% probability of success, works. It’s just inside the expected range, but we can adjust accordingly if needed. I want to have an opportunity to bring in 13.6% over the next 32 days, while keeping my probability of success at the onset of the trade to around 85% or higher.
The short 465 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 465 call strike at the March expiration in 32 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 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 spikes to the upside over the next 32 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 465 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: March 18, 2022, 465/470 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open SPY March 18, 2022, 465 strike call.
Buy to open SPY March 18, 2022, 470 strike call for a total net credit of roughly $0.60, or $60 per bear call spread.
- Probability of Success: 88.29%
- Total net credit: $0.60, or $60 per bear call spread
- Total risk per spread: $4.40, or $440 per bear call spread
- Max Potential Return: 13.6%
Again, as long as SPY stays below our 465 strike at expiration in 32 days, I have the potential to make a max profit of 13.6% 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 $0.60, I would look to buy it back when the price of my spread hits roughly $0.30 to $0.15, 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.
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 465/470 bear call spread for $0.60, if my bear call spread reaches approximately $1.20 to $1.80, 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.