How to Generate Income While Limiting Losses

Many investors are familiar with buying options. Far fewer are familiar with selling (aka “writing”) options.

When you sell an option, you hope it expires worthless or that you can buy it back at a lower price.

You receive premium by writing options, so it can be a great income-generating strategy.

But it also comes with increased risk if you don’t fully understand your obligations.

That’s why spreads are one of the most popular options strategies. A spread is when you buy and sell a pair of call or put options simultaneously.

It’s a strategy I use almost daily with my options advisory, The S&P Trader. That’s because it enables you to generate income while capping potential losses…

$268 in a Day

To explain how it works, I want to share a trade I did a couple of weeks ago. It made a handy $268 gain per contract in just a day. (If you traded two contracts, you could have made $536, for example.)

In this case, we used a Bear Call Spread.

The name of the strategy refers to a couple of components.

First, it’s a bearish position. (We think the market will stay flat or drop.) And second, we buy and sell call options at the same time (a spread).

To see how it works, let’s pull up the S&P 500 chart:

S&P 500 Index (SPX)

Source: eSignal

On the day of the Federal Open Market Committee (FOMC) meeting, SPX rallied (orange arrow). The Fed reconfirmed that it intends to cut rates three times in the latter half of this year.

The following day (March 21), SPX gapped higher. But its rally soon fizzled out, and it started drifting lower.

This coincided with the Relative Strength Index (RSI) making an inverse ‘V’ from overbought territory in the bottom half of the chart.

This provided the perfect scenario to put a bear call spread to work.

How to Win With a Bear Call Spread

When you place a bear call spread, you sell a call option at a level above where you think the market will go.

This time, we wrote our call at a 5270 strike price – with a same-day expiry.

(Note that it’s a trade-off. The closer the strike price is to the current index level, the more premium you’ll receive as income. But this increases the chance of your option being exercised and turning into a losing trade.)

Now, if we just wrote the call by itself, we could be setting ourselves up for massive losses if SPX broke through the 5270 level and kept rallying.

That’s where the second leg of the spread trade fits into the picture.

We also buy a second call option at a higher strike price. This leg acts like a stop loss.

And keep in mind, we sell and buy these two call options at the same time. Together, they act as a single position.

By simultaneously buying an SPX call at a 5290 strike price (and same-day expiry as well), our losses are capped if SPX rallies past both legs.

In this case, our trade put a combined premium of $2.68 (or $268 per contract) into our account. (The premium we earned by selling the first call option is more than the cost of buying the second call option.)

SPX closed at 5241 on the day – well below both strike prices (5270 and 5290). So that premium remained ours to keep.

Had SPX rallied to 5300, for example, the most we could have lost is the difference between the two strike prices (5290 – 5270 = 20 points, or $2,000). We would also factor in $268 premium we received, so our max loss would be $1,732.

But on the flip side, this strategy allowed us to earn our premium in just one day.

And if you do that successfully week in and week out, that can add up to some really substantial income. That’s the power of using bear call spreads as a trading strategy.

Larry Benedict
Editor, Trading With Larry Benedict