How I Approach a Trade in an Overbought ETF - Cabot Wealth Network

How I Approach a Trade in an Overbought ETF

Each week I send out my High-Probability Mean Reversion Indicator which includes roughly 25-35 highly liquid ETFs. In the next few months, I’ll be doing the same with a highly liquid list of stocks as well.

The list contains the overbought/oversold levels of each ETF as well as the current implied volatility and IV rank. And at the moment, we have quite a few ETFs that are considered overbought. One of the most overbought at the moment is the SPDR S&P 500 ETF (SPY).

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Make Money in This Market

As I’ve explained in the past, there are numerous strategies that we can use when a highly liquid ETF hits an overbought state, but my favorite is a bear call spread.

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.

With SPY now trading for roughly 440 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 April 22, 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 April 22, 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.

DIA-bear-call-spread

Since we are focused on using a bear call spread, we only care about the upside risk at the moment.

The 462 call strike, with an 80.86% 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 24.1% over the next 35 days, while keeping my probability of success at the onset of the trade to around 80% or higher.

The short 462 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 462 call strike at the April expiration in 35 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 35 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 462 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: April 22, 2022, 462/467 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 April 22, 2022, 462 strike call.

Buy to open SPY April 22, 2022, 467 strike call for a total net credit of roughly $0.95, or $95 per bear call spread.

  • Probability of Success: 80.86%
  • Total net credit: $0.95, or $95 per bear call spread
  • Total risk per spread: $4.05, or $405 per bear call spread
  • Max Potential Return: 24.1%

Again, as long as SPY stays below our 462 strike at expiration in 35 days, I have the potential to make a max profit of 24.1% 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.

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 $0.95, I would look to buy it back when the price of my spread hits roughly $0.45 to $0.30, 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 462/467 bear call spread for $0.95, if my bear call spread reaches approximately $1.90 to $2.85, 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.

Comments

  • David R.

    Hi Andy, A little confused. In the body of your report you refer to “I also tend to set a stop-loss that sits 1 to 2 times my original credit” which you go on to say is $1.90 to $2.85. However, in the Q&A you state the stop loss should be “2 to 3 times our original premium.”

    So which one is it?

  • I went ahead and used your Delta guidelines on DIA and came up with a 22Apr22 358/363 Call Credit for 90 cents. Looks like it is working just fine.

  • paul m.

    Correct me if I am wrong, but if you have a 80% chance you will be successful leaves a 20% chance you are not. If you made 10 trades with the numbers you are using above you would be making lets say $45 (1 contract) times 8 or $360. on the other hand you will be losing 20% of the time in the amount of $400 (total risk) or $800. So do you get out of the losing trade sooner? If not I don’t see how this makes money based on your example over time.

    Thank you for your time

    • Andy C.

      Paul,

      Thanks for the question, it is one that I receive fairly often. You are making the assumption that every losing trade is a max loss. In fact, that’s rarely the case. And if you look at the probabilities of taking a max loss on a spread per say the long strike (where you define your risk) is often at say, 9%. Moreover, we set stop losses at roughly 2 to 3 times our original premium. I realize this is a fairly simplistic example, but it points out why the 80/20 example doesn’t work. I hope this helps and please feel free to post here with any further questions. I am more than happy to help.

  • Hi Andy, I love reading your posts. I think it’s really educational how you break it down.

    I don’t see the 462 option for DIY today.

    Thanks
    Sunil

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