Get Bearish With Call Spreads
Often times when traders hear the term “call spread” they think of the more traditional bull call spread. This bullish trade is likely the first spread thought of because it contains the word “call,” which is generally perceived as bullish, while puts are regarded as being bearish.
But just like we showed how put spreads can be bullish trades rather than bearish simply by selling the spreads as opposed to buying them, we can do the same thing with call spreads.
That’s right. By selling call spreads as opposed to purchasing them, we are effectively taking a neutral to bearish position in the underlying stock. They work as such:
Shares of ABC are trading at $100. We are bearish on the stock and so we agree to sell the $105 call for a credit of $1.00 and buy the $110 call options for a debit of $0.25. In all, we collect a net credit of $0.75.
Because we are shorting the $105 calls as opposed to buying them, we are expecting the stock to trade below that mark by expiration.
This part is important: While selling call spreads admittedly comes with less reward than buying a call spread, the flexibility is much more attractive. Consider our example. If we were to buy the $105/$110 call spread for $0.75, we would need the stock to appreciate 5.75% just to get to our breakeven price of $105.75.
But by selling the spread as opposed to buying it, we can actually have the stock move 5% in the wrong direction – up to $105 – and still hit our maximum profit, which would be keeping the full credit of $0.75.
So long as the stock trades lower, flat or even slightly higher, our trade will be profitable. The same cannot be said for those buying call spreads. In fact, when buying call spreads, traders can actually be right on the direction and still lose money if they do not time the trade correctly or choose the right strike prices.
By selling call spreads though – or put spreads for that matter – traders can actually be wrong and still hit their target goals.
Of course, that’s not to say buying option spreads don’t have a place in our trading arsenal. Like anything in the market, there are times to be the buyer and times to be the seller.
But the merits of selling spreads as opposed to buying them seemed like they needed to be highlighted, given the number of options traders out there that assume selling options is far less rewarding than buying.
A Real Trade in the Making
Before we go any further, let’s take a look at a real-world trade.
Like the bull put spread trade we looked at earlier this month (linked above), I opted for conservative results rather than aggressive ones. Luckily for investors using OptionParty, the day of scanning and calculating by hand are long gone. Simply input the required risk/reward metrics, adjust how conservative or aggressive you want the trade to be and decide which best fits your situation.
If none of the results are particularly fitting, that’s fine too. It simply means now is a good time to sit on your hands. For us however, we received some fine results from the scan. Below are the top 10 results, ranked by OptionParty’s Party Rank:
As you can see, there are several attractive trades in the bunch. all of them have the potential to generate more than 5% return-on-risk, while all sporting a total loss probability of 5% of less, with three results even sporting sub-3% total loss potential.
I will start with those three, since the risk appears to be the lowest, without sacrificing any significant upside, as each still has return-on-risk potential of 5% or more. It appears the two best trades boiled down to No. 1 Nvidia (NVDA) and No. 8 Twitter (TWTR).
With its 1.6% total loss probability and 5.2% return-on-risk potential, Twitter looks pretty attractive. However, Nvidia’s 89.7% target return probability and 90.3% profit probability both trump Twitter’s results.
In the end though, there’s one glaring issue: Both report earnings before our positions expire.
While the risks appear low now, a strong earnings report could fuel these stocks much higher before our options expire. Since the goal with a bear call spread is to see the stock trade lower, sideways or even slightly higher, a strong rally could spell trouble for the risk side of our trade.
For that reason, we should turn our attention to the third trade, Newmont Mining (NEM). The trade boasts a 5.2% return-on-risk potential and only a 2.7% total loss probability, second-best among the top 10 trades.
Its target return potential and probability of profit both lag that of the Nvidia trade, but are both better than Twitter. Most importantly, the trade expires on February 17th, five days before the company is scheduled to report earnings.
Some traders like to position themselves ahead of earnings. However, earnings can be a bit of a gamble. A “gamble” translates to “risk,” and as a premium seller, we are trying to mitigate those risks. It is for that reason that Newmont presents our ideal trade in this scenario.
The trade involves selling the February $40 call for $0.20 and buying the February $42 call for $0.05. In the end, we are collecting a net credit of $0.15, giving us a breakeven of $40.15.
If the stock closes below that price on expiration, we profit. Above it, we see losses. Even if the stock moves all the way up to $40 and closes at that level though, we will still realize our maximum gain.
As exhibited in this situation, sometimes this old cliché applies: The best offense is a good defense.
By not opening ourselves up for unwanted risk, we can maximize our potential for reward. In this case, and in all cases of selling premium really, the goal is to maximize reward and minimize the risk. By reducing the likelihood of a big move in the stock, we can increase our odds of success.