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In the past four articles we discussed a bear call spread and then an adjustment to an iron condor. In this real-world example we have seen the worst-case scenario, one in which the max risk has been realized. Before we go into the details and what we can learn from this, let’s look at the data.

02/07/2005
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

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Current Loss = 1.05 or $525
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread Adjustment
Add a 110-115 Bull Put Spread
Buy 5 Mar 105 puts @ 0.35
Sell 5 Mar 110 puts @ 1.30
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85
Current Loss = $575 (getting inside the spread)

02/22/2005
TOT @ 115.30
110-115 Bear Call Spread Adjustment
5 Mar 105 puts @ 0.05 (sell)
5 Mar 110 puts @ 0.25 (buy)
5 Mar 110 calls @ 5.60 (buy)
5 Mar 115 calls @ 1.95 (sell)
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85
Current Loss = $850 (getting inside the spread)

3/15/2005
TOT @ 120.32
110-115 Bear Call Spread Adjustment
5 Mar 105 puts @ 0.00 (sell)
5 Mar 110 puts @ 0.05 (buy)
5 Mar 110 calls @ 10.60 (buy)
5 Mar 115 calls @ 5.30 (sell)
Current Loss = $1600
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85

As these articles have progressed, we talked about exit points, which all would have been hit, but we wanted to see how the trade worked nonetheless. Looking at the data as of March 15 we see that the current loss is greater than the max risk. The obvious question is how is this possible? The reason is that there is still some cost associated with closing out the options that are well out of the money. However, if this stock were held until expiration Friday, the max loss would be $1430.

This trade is a perfect example of why we use stop losses and why we have to look at the long term. We can make small amounts of money on credit spreads, but one large loss can wipe these losses out. Though we like to use stocks with high implied volatility when entering credit spreads like a bear call spread, we have to balance out the higher risk associated with high IV options.

In general, we would expect to profit using a credit spread 67 percent of the time. This is because using an at-the-money credit spread we have three possible directions a stock can go. If we are using a bear call spread, we profit if the stock stays the same or moves lower and we only lose if the stock rises. This means we win two-thirds of the time or 67 percent. By using technical analysis, we should be able to win even more than this. At the same time, we also should set stop losses so that we get out of the trade before the max loss is hit.

Using Platinum, we can backtest credit spreads to see how they perform. We can do this by setting the Platinum date back and then searching for credit spread candidates. From there we treat the trade just like it was real; setting up stop and profit exits. After this we can forward the date to see how the trade would have fared. If any readers have strategies that seem to work well and they are willing to share them, please post this information 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
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