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Earnings season can be a very volatile time for stocks, but this can be a good thing for option traders. One strategy that can be implemented during earnings season is the bear call spread. This strategy is a credit strategy and is bearish in nature. Its makeup consists of selling a lower strike call and buying a higher strike call. The result is a credit that is kept as long as the stock closes at or below the lower strike at expiration. Since this is a strategy that benefits from time decay, we normally want to use short-term options. In order to better understand this strategy, let’s enter a mock trade and follow it through to expiration.

One way to find possible candidates for this strategy is to search high IV stocks and then eyeball the charts. One stock that caught my attention when running a search for bear call spreads was ConocoPhillips (COP). This is a major oil company, thus its shares have experienced strong gains this past year. However, heading into its earnings report on July 27, the stock has run into some resistance near the $60 level. The stock is expected to announce very strong earnings, but it looks like this news has been priced into the stock. At the same time, oil prices look to be heading down in the near term. As a result, we can enter a short term bear call spread. Below is the data for this mock trade:

June 19, 2005
COP @ $60.57
Buy 5 Jul 62.50 calls @ 1.05
Sell 5 Jul 60 calls @ 2.05
Total Credit = $500
Max Risk = $750
Max Reward = $500
Breakeven = $61.00

As the data shows, we are risking $150 for every $100 we can make. However, we only need the stock to stay where it is to make a profit. Any decline in price will provide a larger profit until the max reward is reached when the stock is below $60. The max loss would occur at a price above $62.50 at expiration. The idea is that COP shares will decline on its earnings announcement and this will push the trade into max profit territory. After besting earnings by a large margin in the first quarter, expectations are for similar results in the second quarter. This means that only very strong results will be enough to push the stock higher. At the same time, the stock will need oil prices to remain elevated.

To get a better understanding of the risk associated with this trade, we need to look at a risk graph.

Figure 1: Risk Graph for COP Mock Trade

Though we are risking more than we can profit, this doesn’t mean the trade is a bad one. We have to look at the odds of success as well. With this trade, we would profit if the stock stays flat or moves lower, which puts the odds in our favor. By looking at other data, like the move the stock has experienced and the positive news already out, this looks to be a great candidate for a bear call spread.

We’ll track this trade each week until August expiration to see how it performs. Please feel free to express your thoughts and to ask questions about this strategy and trade 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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