No one truly knows where this market is headed.
Some professional analysts tout bullish days ahead and just as many state the opposite.
The truth is, no one knows. No one has a crystal ball. This is why I trade options. Because I have no clue where the market is headed. Yes, I have a directional bias from time to time, but my conviction doesn’t guarantee a profitable result.
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It’s probabilities. It’s implied volatility. It’s focusing on a small watchlist of highly liquid stocks and ETFs. These are the items that truly give me the insights I need to make rational trades using the appropriate strategy for the current market environment.
As I stated over the past few months, credit spreads are great strategies for this market environment, particularly for those who prefer risk-defined options strategies.
Volatility is fairly high across the board. Just look at the VIX for reference.
Just look at the IV rank. Its currently pegged.
IV rank is an important tool when measuring the current levels of implied volatility in a stock or ETF. The volatility measure tells us if the current implied volatility is high or low compared to levels of volatility over the past 12 months.
And in a high implied volatility environment, like what we are witnessing in today’s market, credit spreads make the most sense. I would argue they are wonderful for any market environment, but when volatility is notably high, credit spreads are the preferred strategy.
Remember, heightened levels of implied volatility bring higher levels of premium. The higher levels of premium allow options traders the choice to increase probabilities while bringing in the same amount of premium. Or keep probabilities at normal levels (typically around 80%) and bring in more premium with less risk on the trade.
Thankfully, we’ve had some good fortune using bear call spreads on the major market ETFs through bullish, neutral and now bearish market environments over the past several months, and my guess is if the VIX continues to linger above 18, premium selling options strategies will continue to thrive.
So, as a result of the current heightened state of volatility, I’m going to place another bear call spread in SPY. This will mark our 9th trade using bear call spreads over the past several months.
I posted my last trade idea last week. Today, we can take off that trade for roughly 8% to 10%.
The Trade
With SPY trading for 440.87 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.
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 .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 471 call strike, with an 84.99% 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 19.0% over the next 51 days, while keeping my probability of success at the onset of the trade to around 85%.
The short 471 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 471 call strike at the March expiration in 51 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 51 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 471 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, 471/476 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Simultaneously:
Sell to open SPY March 18, 2022, 471 strike call.
Buy to open SPY March 18, 2022, 476 strike call for a total net credit of roughly $0.80, or $80 per bear call spread.
- Probability of Success: 84.99%
- Total net credit: $0.80, or $80 per bear call spread
- Total risk per spread: $4.20, or $420 per bear call spread
- Max Potential Return: 19.0%
Again, as long as SPY stays below our 471 strike at expiration in 51 days, I have the potential to make a max profit of 19.0% 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 $0.80, I would look to buy it back when the price of my spread hits roughly $0.40 to roughly $0.20, 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 410/476 bear call spread for $0.80, if my bear call spread reaches approximately $1.60 to $2.40, 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.