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 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 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, then buying a put option is the way to go. They profit when the underlying asset falls.
But 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 is a “bear call spread.” (And I use it frequently in my advisory The S&P Trader.)
If you’re new to options, this name might sound a bit confusing.
But it simply means we are “bearish” and that the strategy uses call options. 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 rallied strongly, but look at the relative strength index (RSI) indicator in the bottom of the chart (red circle). The RSI tells us that SPX is fast approaching overbought territory (upper gray dashed line).
And given that SPX rallied over 10% in just a few weeks, we may think its rally could run out of steam soon.
So, if we believe that SPX is unlikely to trade above 4600 (Level 1), then we could 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 4600 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 see big losses.
That brings us to the second piece of our trade: managing risk.
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Risk Management Is Key
Although there are two legs to the trade, we treat this spread 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 4650, with the same expiry date as the first leg.
That way, we limit the amount we can lose on the trade. Basically, this option acts like a stop loss if the market decides to soar.
Take another look:
S&P 500 Index (SPX)
Source: e-Signal
If we sell our first call option at 4600 and buy our second call option at 4650, 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.
But if our analysis is right and the market stays mostly flat or down, then we’ll 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 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 that credit as income.
Often investors get frustrated when they look at a stock or index that looks like it is topped out or stuck trading in a sideways range.
But by using a strategy like a bear call spread, you can generate some handy income even when the market is going nowhere.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict