The SPDR S&P 500 Oil & Gas ETF (XOP) has pushed into an extreme overbought state. Typically when this type of extreme reading occurs the directional trend stalls or simply pulls back, at least momentarily.
Now, I know I don’t have the ability to consistently “guess” the direction a stock or ETF is headed over really any time frame. But what I can do is consistently wrap a high-probability strategy around an extreme in the market and offer myself an 80%+ probability of success on each trade I place.
And that’s exactly what I want to attempt today in XOP.
Let’s walk through the trade together.
XOP is currently trading for 168.62 with an overbought reading of just under 92.
So, because of the extreme overbought reading, I want to apply an options selling strategy with a bearish slant that allows me to create a large margin of error by taking on a trade with a high probability of success.
The Trade
Again, with XOP trading for 168.62 I want to place a short-term bear call spread going out 37 days. My intent is to take off the trade well before the July 15, 2022 expiration date. It could be two days or two weeks, but I rarely hold my position through 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 July 15, 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 0.25, as seen below.
Since we are focused on using a bear call spread, we only care about the upside risk at the moment. For this bearish spread example, my preference is to go with a trade that has around a 70% to 80% probability of success.
The 190 call strike, with an 83.69% probability of success, works. It’s just outside the expected range, and we can always adjust accordingly if needed. I want to have an opportunity to bring in 16.3% while keeping my probability of success around 80%.
The short 190 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 190 call strike at the July expiration in 37 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 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 37 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 190 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: XOP July 15, 2022, 190/195 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Simultaneously:
Sell to open XOP July 15, 2022, 190 strike call.
Buy to open XOP July 15, 2022, 195 strike call for a total net credit of roughly $0.70, or $70 per bear call spread (price may vary, please adjust accordingly)
- Probability of Success: 83.69%
- Total net credit: $0.70, or $70 per bear call spread
- Total risk per spread: $4.30, or $430 per bear call spread
- Max Potential Return: 16.3%
Again, as long as XOP stays below our 190 strike at expiration in 37 days I have the potential to make a max profit of 16.3% 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 $0.70, I would look to buy it back when the price of my spread hits roughly $0.35 to roughly $0.15, 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 190/195 bear call spread for $0.70, if my bear call spread reaches approximately $1.40 to $2.10, I will exit the trade.
If you have any questions, please do not hesitate to email me at andy@cabotwealth.com.