While many of the stocks that reside in the major indices have taken a step back in 2022, there is one sector that continues to make historic strides.
According to Jason Goepfert of Sundial Capital Research, “A funny thing has been happening in stocks since late February. Stocks usually relegated to widows and orphans have behaved like supercharged tech stars. The Dow Jones Utility Average enjoyed its 2nd-largest 30-day rate of change in 20 years. The surge has been so great that more than 60% of them became overbought on an average day over the past 2 weeks.”
Unfortunately, the exuberance in safe, steady investments might be coming to an end. Geopfert goes on to state, “the jump in overbought stocks pushed more than half of them to 52-week highs on an average day over the past 10 sessions, a 23-year record. This type of price action in utility stocks shows “that future returns are horrid when the 10-day average reaches even 40%”.
Courtesy of Sentimentrader.com
As a result of the statistics stated above and the current overbought state in SPDR Utility ETF (XLU), I want to sell a vertical call spread (bear call spread) with at least an 80% probability of success.
Let’s see what we can come up with for a potential trade.
Selling A Vertical Call Spread
XLU is now trading for roughly 76.09. Given the stats mentioned above, I want to place another short-term bear call spread going out around 30-50 days while keeping my probability of success around, if not above, an 80% probability of success.
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.
But when looking at the options chain for XLU, the bid-ask spreads are just too wide. So, let’s take a look at another alternative, the top holdings for XLU.
After sifting through the options for the companies listed above, I’ve decided to look at a potential high-probability trade in Duke Energy (DUK).
Once I’ve chosen my expiration cycle (it will differ in duration depending on outlook, strategy and risk), in this case the May 20, 2022, expiration cycle, I begin the process of looking for a call strike within that 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 selling a vertical call spread (bear call spread), we only care about the upside risk at the moment.
The 120 call strike, with an 82.09% 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 11.1% over the next 33 days, while keeping my probability of success at the onset of the trade around 80% or higher.
The short 120 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 DUK stays below the 120 call strike at the May expiration in 33 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, DUK spikes to the upside over the next 33 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 120 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: May 20, 2022, 120/125 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open DUK May 20, 2022, 120 strike call.
Buy to open DUK May 20, 2022, 125 strike call for a total net credit of roughly $0.50, or $50 per bear call spread.
- Probability of Success: 82.09%
- Total net credit: $0.50, or $50 per bear call spread
- Total risk per spread: $4.50, or $450 per bear call spread
- Max Potential Return: 11.1%
Again, as long as DUK stays below our 120 strike at expiration in 33 days, I have the potential to make a max profit of 11.1% 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.
I look to buy back a spread when I can lock in roughly 50% to 75% of the original credit. Since we sold the spread for $0.50, I would look to buy it back when the price of my spread hits roughly $0.25 to $0.10, 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 is 2 to 3 times my original credit. Since I’m selling the 120/125 bear call spread for $0.50, if my bear call spread reaches approximately $1.00 to $1.50, 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.