Iron condors…
Butterflies…
Ratio backspreads, straddles, and strangles…
The options world wins hands-down when it comes to inventing crazy names.
But while options strategies might sound confusing, they include just two component parts: a call and/or put option.
If you understand how each piece works, then you can construct a strategy that fits just about any possible scenario you can imagine.
And you can profit no matter what the market is doing – even when it’s going nowhere.
A Strategy for Any Occasion
When you think a stock is about to rocket higher, you might simply buy a call option. Call options profit when the underlying stock rises.
If you think a stock could plummet, on the other hand, then buying a put option would be the way to go. They profit when the underlying asset falls.
However, what should you do when you think a stock or index will go nowhere? That is, if you think it might trade sideways or generally drift over time?
One strategy I have used profitably for decades to trade this exact situation (and use in my advisory The S&P Trader) is a “bear call spread.”
If you’re new to options, this name might sound a bit confusing.
But it simply means we are bearish, and the strategy uses call options. And because it’s a spread, we buy and sell call options at the same time.
To see how it works, look at the chart of the S&P 500 Index (SPX) below…
S&P 500 Index (SPX)
Source: e-Signal
SPX has been trading in a sideways rangebound pattern since April.
Our two moving averages (MA) – the 10-day MA (red line) and 50-day MA (blue line) – are tracking closely together. And our momentum indicator, the Relative Strength Index (RSI), is gently tracking lower.
So if we believe that the SPX is unlikely to trade above 4200 (Level 1), then we could write (sell) a call option at that level to pick up income. (Please note that is this just an example, not a trade recommendation.)
If SPX is trading below 4200 when the option expires, then we bank the premium we collected and ready ourselves for another potential trade.
But if our analysis is wrong and SPX rallies above that level (‘1’), we could potentially be in for big losses.
That brings us to the second piece of our trade, which helps us manage that risk…
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Risk Management Is Key
Keep in mind – although there are two legs to the trade, we treat the trade as one position.
The second leg of our trade (level ‘2’) is another call option we buy at a higher strike price, such as 4250, with the same expiry date as the first leg.
Take another look:
S&P 500 Index (SPX)
Source: e-Signal
That way, we limit the amount we can lose on the trade. In effect, this option acts like a stop loss if the market decides to soar.
If we write (sell) our first call option at 4200 and buy our second call option at 4250, then the most we can lose is the 50 points between our two strike prices. And the premium we receive from selling the first option helps offset that potential loss even more.
Yet if our analysis is right and the market stays mostly flat or down, then we will make money.
That’s why you’ll also see a bear call spread referred to as a “credit” trade. You’re receiving money because the bought call option (‘2’) is cheaper than the written (sold) call option (‘1’). So you end up with a credit in your account.
And if the trade goes your way, you get to keep all of that credit as income.
Often investors get frustrated when they look at a stock or index that is stuck trading in a sideways range.
However, by using a strategy like a bear call spread, you can generate some handy income even when the market is meandering nowhere.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. If you’d like to learn more about how this strategy works in The S&P Trader, you can find out the details here.
Mailbag
In today’s mailbag, a couple members of The S&P Trader share their experiences with spread trading…
First 26 trading days, profit is now up to $52,014. Profit rate so far is more than four times my maximum salary when I was working 40 to 80 hours per week.
– J.R.H.
I love The S&P Trader and the strategy behind it. With volatility running low, seems like a well-planned trade can make trades very predictable & profitable. Thanks.
– David S.
Thank you for sending in your feedback. We look forward to reading it every day at [email protected].