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We’ve been tracking the movement of a bear call spread during the past three weeks. We used ConocoPhillips (COP) as our stock, feeling that oil prices had maxed and would drop. However, this was not correct and oil prices have since hit record highs. As a result, COP shares have moved to new highs as well, creating a loss in our bear call spread trade.

When we started this mock trade, COP shares were at $60.57 and we just needed them to stay below $61 to make a profit. Because the stock was trading near new highs, we expected COP’s earnings announcement to create some profit taking, but this did not occur and the stock has continued to rise along with oil prices. Below is the week-to-week data for this 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

June 27, 2005
COP @ $62.17
5 Aug 62.50 calls @ 1.40 (Sell)
5 Aug 60 calls @ 3.00 (Buy)
Total Credit = $500
Current Loss = $300
Max Risk = $750
Max Reward = $500
Breakeven = $61.00

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

July 27, 2005
COP @ $62.17
5 Aug 62.50 calls @ 1.40 (Sell)
5 Aug 60 calls @ 3.00 (Buy)
Total Credit = $500
Current Loss = $300
Max Risk = $750
Max Reward = $500
Breakeven = $61.00

August 2, 2005
COP @ $64.38
5 Aug 62.50 calls @ 2.45 (Sell)
5 Aug 60 calls @ 4.60 (Buy)
Initial Credit = $500
Cost to Exit = $1075
Current Loss = $575
Max Risk = $750
Max Reward = $500
Breakeven = $61.00

There are various exit strategies for credit spreads and each of these are based on the individual traders’ risk tolerance. When using credit spreads, we expect to profit 67 percent of the time. This is because a stock can move higher, stay the same or move lower. Most credit spreads profit if two of these scenarios take place. Some traders might have chosen to exit once the loss equaled the $500, as this would equate to a reward-to-risk of 1.0. Over time, we if win two thirds of the time, exiting with a loss that equals the reward should result in profits. Others might be willing to hold onto credit spreads until expiration if the reward to risk was at list 2-to-3, which is what this trade was. We had a possible reward of $500 with risk of $750.

August option expiration is two and a half weeks away and COP would have to fall 5.25 percent to hit our breakeven point. Nonetheless, just to show how a bear call spread works as expiration approaches, we will continue to track it until expiration. I’d love to hear from our readers on my forum about their exit strategies for credit spreads and/or the way they find and trade this strategy.

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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