Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Last week we began a discussion about the make up of a bear call spread. This bearish strategy brings in a credit and normally profits if the underlying security moves sideways or lower. The trade is made up of selling a lower strike call and buying a higher strike call. We normally sell a call that coincides with resistance for the stock. Because we benefit from time erosion with this strategy, we usually want to use front month options as well. This week, we will walk through a possible process in finding candidates for a bear call spread. We will also choose a stock to enter a mock trade on using this strategy and we will follow through out its existence.

Before we find a trade, let’s discuss what we are looking for in candidates for a bear call spread. First and foremost, we want a stock that is not going to move substantially higher. We also would like to find a stock that has options showing high implied volatility. Why? Because the higher the volatility, the more the initial credit will be. However, this doesn’t mean we can’t make money using options that are showing average IV. Using this criterion, we can then choose a method to narrow our choice of stocks.

One method in finding bearish stocks or at least stocks that are not likely to move higher, is candlestick patterns. In Platinum, we have a tool called Candlestick II Patterns. Candlestick’s have patterns that develop that tend to be bearish, one of which is the “evening star.”  Therefore, we will use these ranking criteria to find possible candidates. On the right side of the Candlestick Patterns II screen, we can choose to search from a broad range of stocks or by using a saved stock list. One example would be to use a list of high IV stocks. However, for this trade we will use the universe of optionable stocks using the default criteria.

Using the three day bearish patterns tool, a total of seven possible stocks were returned. As I look at the list, I want to find a stock that is trading near a possible strike price. The list that was returned is shown below:

Figure 1: List of Bearish Candlestick Candidates

As I looked through the list, I notice that Total Fina (TOT) closed Monday’s session at $108.83. This looks like a good candidate, so I then looked at the chart of the stock. Looking at the chart of TOT, we quickly see that it has resistance at $110, which is exactly what we want. The one caveat is that implied volatility is actually lower than average. Nonetheless, if the stock were to close below $110 by March expiration, a nice profit could be made.

A chart of the stock is shown below:

Figure 2: Daily Chart of TOT

We need to use March options because February options aren’t providing enough premium to make the trade worth while. The March 110-115 bear call spread provides us with the following trade:

TOT @ 108.83
110-115 Bear Call Spread
Sell 5 Mar 110 calls @ 1.65
Buy 5 Mar 115 calls @ 0.45
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

The max reward in a credit spread is the credit received. The max risk is found by taking the spread of five points and subtracting out the credit (5 – 1.20 = 3.80). If we multiply this by five contracts we come up with the $1,900 risk. The breakeven is found by taking the lower strike and adding the credit received (110 + 1.20 = 111.20). Below is a snapshot of this trade in Platinum:

Figure 3: Risk Graph Data for TOT Bear Call Spread

This leaves us with a trade that has a lot of risk compared to reward. However, the odds of success are much higher. Basically, we will make money as long as TOT shares rise less than $2.40.

We always should have exit points set up in advance, so let’s discuss what our exits will be. The 52-week high for the stock sits at 110.56, so let’s say that our exit points will be 111.00. Depending on when this occurs, this will limit our losses. As far as a profit exit, we most likely will just hold on until expiration Friday and then exit with a profit. If we see a large decline in the near term, we can close out the trade if we reach 80 percent of our max profit.

Each week, we will visit this mock trade to learn how a bear call spread works. For those that have questions or comments, please feel free to post them on my forum.

To read previous installments of Real-World Trading, please click here.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jody's Forum 

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• November 19, 2008
  Economic Watchdog, November 19
• November 19, 2008
  Closing Wrap-Up, November 19
• November 19, 2008
  Morning Watch, November 19
• November 18, 2008
  Economic Watchdog, November 18
• November 18, 2008
  Closing Wrap-Up, November 18