REAL-WORLD TRADING: Using a Bear Call Spread (Part II)
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October 3, 2001
Last week, we started a series of articles on how to use a bear call spread. In it, we discussed the characteristics of this bearish credit strategy. The list below details five criteria that should be present when choosing a stock for this strategy.
1. Should be slightly bearish on the stock.
2. Use options that are overvalued if possible.
3. Find a stock that has strong overhead resistance.
4. Look at overall probability of profit, not just the risk/reward ratio.
5. Normally use options that are less than 45 days out to take advantage of time erosion.
This week, we’re going to start following a mock trade using a bear call spread. As I searched for stock’s that fit the above criteria, I came across Boeing (BA). It’s debatable whether this stock is perfect for this strategy, but it does fit the above criteria and by using October options, we can learn this strategy using BA over the next few weeks.
Boeing has fallen sharply since the September 11 attacks, going from the mid-45’s to a price in the low 30’s. The decline in airline travel and orders for commercial planes has taken its toll on BA. Over the last week, the stock has consolidated just above $30, with $35 providing strong resistance. Today, the stock rose sharply after Boeing stated they have signed an agreement with China for 30 Boeing 737 jetliners. The order is worth approximately $1.6 billion. Even so, BA shares still could not break through resistance at $35. Considering this level has kept the shares in check, we are going to use a bear call spread using the October 35 and October 40 calls. Remember, a bear call spread is bearish in nature, but we still use calls to bring in a premium. Below is the information used in our mock bear call spread.
October 2, 2001
Price of BA – 34.25
Sell Oct 35 Call @ 1.30 IV-54.63 (based on bid)
Buy Oct 40 Call @ 0.35 IV-64.54 (based on ask)
Total Credit = 0.95
Maximum Profit = 0.95
Maximum Risk = 4.05
The first thing many traders will notice is that the risk reward ratio is quite high, with $4.05 at risk and a maximum reward of just $0.95. However, we should only enter a bear call spread when we are bearish on the stock and there is evidence that the stock is not going to move above our sold call. In this case, we feel that $35 will hold BA down and that BA is not in a position to rise sharply considering the market environment.
Using the above data, our breakeven on this trade is 35.95. Our maximum loss is reached if BA closes at or above $40 at expiration. Since there is money at risk that we haven’t paid for, there will be a margin requirement from you broker. However, the amount of margin needed should be rather low considering only $4.05 is at risk per contract. If we were taking in a credit by selling a naked call, the margin would be substantially higher and our risk would be unlimited.
If the stock moves above $35, traders may want to look at closing out the trade at break even or with a minor loss if it seems it will continue higher. On the other hand, if BA moves significantly lower, traders may want to close out the trade by buying back the sold call for a minor amount to get the use of used margin. However, many traders just let this trade expire so that commissions are lower.
Next week, we’ll update how this trade has done and see how another week of time erosion has affected our bear call spread. Since we are selling options, time erosion works in our favor and this is the reason why we like to use options that are showing high implied volatility compared with their past values. This definitely holds true for BA, as its IV has nearly doubled over the last month.
Until next week, good trading.
Joel Addison
Staff Writer & Options Strategist
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