Black Friday marked one of the steepest one-day declines in crude oil history.
Global oil prices plunged 10.7% before recovering a bit Monday. Yes, some of the move lower was exacerbated by the thin trading volume that typically occurs on holiday-shortened sessions, but it doesn’t hide the fact that oil prices have come a long way over the past year or so.
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And if we look at more recent price action in oil, crude has skyrocketed well over 50% in just the past three months. So, a reprieve was in the cards regardless of the source.
What the plunge in oil prices did do for those of us who prefer to use options selling strategies with a high probability of success is give us an opportunity for a potential trade.
With SPDR S&P Oil & Gas Exploration ETF (XOP) trading for 99.90 I want to place a short-term bear call spread going out 18 days. My intent is to take off the trade well before the December 17, 2021 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.
The Trade – Bear Call Spread Example
Let’s start by taking a look at the options chain for XOP with 18 days until expiration. Once we choose our expiration cycle (it will differ in duration depending on outlook and strategy), we begin the process of looking for a call strike within the December 17, 2021 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 0.20, as seen below.
Next, I want to know what the expected move or expected range is for XOP during the December 17, 2021 expiration cycle. The range is currently from 110 to 89.
Since we are focused on using a bearish spread example, we only care about the upside risk at the moment.
By knowing that the market anticipates XOP going as high as 110 by December expiration in 18 days, it allows us to choose a short call strike around that number. This will define our probability of success on the trade.
The 110 call strike, with an 82.72% probability of success, works. It’s outside of the expected range, and we can adjust accordingly if needed. I want to have an opportunity to bring in around 15% to 20%, while keeping my probability of success around 80%.
The short 110 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 XOP stays below the 110 call strike at the December 17 expiration in 18 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.
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, XOP spikes to the upside over the next 18 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 110 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 max risk and my premium increase as my chosen spread width increases.
Bearish Spread Example: XOP December 17, 2021 110/115 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open XOP December 17, 2021 110 strike call.
Buy to open XOP December 17, 2021 115 strike call for a total net credit of roughly $0.60 or $60 per bear call spread.
- Probability of Success: 82.72%
- Total net credit: $0.60, or $60 per bear call spread
- Total risk per spread: $4.40 or $440 per bear call spread
- Max Potential Return: 13.6%
As long as XOP stays below our 110 strike at expiration in 18 days, I have the potential to make a max profit of 13.6% 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 $0.60, I would look to buy it back when the price of my spread hits roughly $0.30 to $0.15.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration 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 110/115 bear call spread for $0.60, if my bear call spread reaches approximately $1.20, 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.