A bear call spread, otherwise known as a short call vertical spread, is one of my favorite risk-defined options strategies.
As the name of the strategy implies, a bear call spread is, well, a bearish-leaning strategy.
But it is important to note that the strategy doesn’t require the security to move lower to make money. Unlike the binary nature of stock strategies, a stock can either go up or down with a bear call spread. So, you not only have the ability to make a return when a security moves lower, you can also make money if the stock stays flat or even if the stock pushes slightly higher.
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For example, take a look at the at-the-money bid-ask spread for SPDR S&P 500 ETF (SPY). As you will quickly notice, the spread is only $0.01…a sign of a highly liquid security.
Now take a look at a security that is considered illiquid.
Below is the bid-ask spread for the VanEck Vectors Agribusiness ETF (MOO).
As you can see, the bid-ask spread is significantly wider than that of the SPY. These are the type of securities I want to avoid. I only want to use efficient products and having to overcome a wide bid-ask spread just doesn’t make sense. I mean, in many cases when using illiquid products like MOO, you have to make 5% to 10% just to get back to break-even, which just doesn’t make sense from an efficiency standpoint. Keep it simple.
So, knowing that SPY is a highly liquid product we can move forward with a potential trade.
Sticking with SPY as our example: With SPY trading for 423.39 and near all-time highs I want to place a bear call spread with a high probability of success.
Let’s take a look at the options chain for SPY going out 28-65 days until expiration.
It looks like the July 16, 2021 expiration cycle with 30 days left until expiration fits the bill. As a result, let’s take a look at the call strike with an 80% probability OTM (out-of-the-money), otherwise known as the probability of success on the trade.
It looks like the 433 call strike with an 80.66% probability of success is where I want to start. The short call strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Once I’ve chosen my short call strike, in this case the 433 call, I then proceed to look at a 3- strike wide, 4-strike wide and 5-strike wide spread to buy.
The spread width of our bear call helps to define our risk on the trade. The smaller the width of the spread the less capital required. 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.
For example, let’s take a look at the 4-strike, 433/437 bear call spread.
The Trade: 433/437 Bear Call Spread
Sell to open SPY July 16, 2021 433 strike
Buy to open SPY July 16, 2021 437 strike for a total net credit of roughly $0.65 or $65 per bear call spread
- Probability of Success: 80.66%
- Total net credit: $0.65, or $65 per bear call spread
- Total risk per spread: $3.35, or $335 per bear call spread
- Max Potential Return: 19.4%
As long as SPY stays below our 433 strike at expiration in 30 days, I have the potential to make 19.4% 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. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.65, I want to buy it back when the price of my spread hits roughly $0.32 to $0.16. 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 by locking in profits is never a bad decision and by doing so, we have the ability to 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 have the ability to 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. In my example, I sold the 433/437 bear call spread for $0.65. As a result, if my spread reaches $1.30 to $1.95 I will exit the trade.