Over the past two weeks, it seems the market has shrugged off all bearishness.
The Nasdaq 100 (QQQ) has climbed an incredible 12.5% since March 15 and the many sentiment measures have quickly turned from bearish to bullish.
But I’m not focused on the so-called bearishness or bullishness that drown the airwaves, as I consider it all noise, what I’m focused on is the current short-term overbought state in QQQ.
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Because when we see an extreme short-term overbought reading in one of the highly liquid ETFs I follow, I want to immediately fade the move. But I want to fade the move using a high-probability approach, just in case the short-term trend continues because a high-probability approach gives me a margin of error.
So with QQQ now trading for roughly 358.50, 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 25, 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.
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 25, 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 378 call strike, with an 83.31% 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 19.8% over the next 28 days, while keeping my probability of success at the onset of the trade to around 80% or higher.
The short 378 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 QQQ stays below the 378 call strike at the April expiration in 28 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, QQQ spikes to the upside over the next 28 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 378 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 25, 2022, 378/382 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open QQQ April 25, 2022, 378 strike call.
Buy to open QQQ April 25, 2022, 382 strike call for a total net credit of roughly $0.66, or $66 per bear call spread.
- Probability of Success: 83.31%
- Total net credit: $0.66, or $66 per bear call spread
- Total risk per spread: $3.34, or $334 per bear call spread
- Max Potential Return: 19.8%
Again, as long as QQQ stays below our 378 strike at expiration in 28 days, I have the potential to make a max profit of 19.8% 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 $0.66, I would look to buy it back when the price of my spread hits roughly $0.33 to $0.16, 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 378/382 bear call spread for $0.66, if my bear call spread reaches approximately $1.32 to $1.98, 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.