Using a Bear Call Spread, Part IV
October 17, 2001
For the past three weeks we’ve been following a bear call spread on Boeing (BA), and today’s article marks the final installment. The options we chose to use for this mock trade expire on Friday, so this trade is coming to an end. I will make sure to update everyone next week about how the trade actually finished, but let’s do some review and discuss what has occurred while we’ve been following this trade.
In review, a bear call spread is much as it sounds. First, it is a bearish strategy, which doesn’t necessarily mean we feel the stock will fall, but that we don’t see it gaining much ground, either. Second, we use calls to create this strategy. In our BA example, when we first entered this mock trade, we felt the $35 level would provide some resistance for BA shares, so we placed a bear call spread using the October 35 and October 40 calls.
A bear call spread is a credit strategy, which means that when we enter the trade, we receive a credit rather than paying out a debit. It may seem like a no-lose situation, but this is not the case. Since we are selling the closer strike, the amount between the two strikes is at risk. In our BA trade, we have a total risk of $5—the difference between the 35 and 40 strikes. However, we took in a $0.95 credit or $95 per spread. This means that our maximum risk $4.05 ($5 subtract the $0.95 credit). Our maximum profit is the credit received of $0.95. We also need to consider commissions, which is the reason why placing credit spreads often involves more than one contract. Below is the information, laid out in a week-by-week format.
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 or $95 per contract
Maximum Profit – 0.95
Maximum Risk – 4.05
October 9, 2001
Price of BA – 36.00
Oct 35 Call @ 2.10 IV-65.37 (based on ask)
Oct 40 Call @ 0.25 IV-57.62 (based on bid)
Total Debit to close trade would equal $1.85
Current Loss - $0.90 or $90 per contract
October 16, 2001
Price of BA – 35.06
Oct 35 Call @ 0.90 IV-68.31 (based on ask)
Oct 40 Call @ 0.00 (based on bid)
Total Debit to close trade would equal $0.90
If sold at closing prices, the trade would have a $0.05 profit, less commissions.
Interestingly, BA shares are trading almost right on our maximum profit point. If the stock were to close at $35.06 on Friday, we would make a total of $0.89. This is figured by taking the amount the stock is above our lower strike, which is $0.06, and subtracting it from the credit received ($0.95-$0.06). If the stock moves above $35.95 at the close on Friday, then we would lose money penny-for-penny up to $40. This is the very reason we enter this trade as a spread rather than selling the 35 call naked. If we just sold the October 35 call, we would have collected $1.30 instead of $0.95, but we would have an unlimited risk. If BA shares shot to $100, we would be liable for every penny above $35.95. Though the likelihood of the stock shooting this high is light, we don’t want to destroy our trading account and financial lives by trying to take in a few more dollars.
Much like a bear call spread, traders may occasionally find that placing a bull put spread works well. A bull put spread works in the same manner, but is a bullish strategy. We would enter a spread that is designed to bring in a credit using puts at a point of support for a stock. During a market environment that has stocks moving back and forth, yet failing to move above support or resistance, traders could use these strategies to make smaller profits. This is much like hitting several singles in baseball, rather than trying for the homerun. Below is a list of the pros and cons of using a credit spread strategy.
Pros
Usually a high probability of profit
Brings in a credit
Easy to find stocks to enter
Limited Risk
Cons
Limited profits
Requires margin account
Risk/reward ratio is high
Can create large commissions if not held to expiration
I may be forgetting some of the other ideas, but these are the main ones. Credit strategies aren’t good in all situations, but when used appropriately, they can help add profits to a trader’s account. Please feel free to visit my forum to discuss this topic further and to list any strategies you would like me to use in future Real World Trading articles.
Joel Addison
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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