As options buyers/sellers, we have a distinct advantage in the equity marketplace. We can craft trade strategies to take advantage of multiple potential trends in the marketplace. Many investors come to the world of options from a background of long equity ownership only. This means that to make a profit on their investments (not including any dividend that may be paid), the underlying equity must ultimately move in a bullish direction to be profitable on the investment – the traditional “buy low, sell high” mentality. If the markets have taught us anything in the past several years, it is that equities don’t always go in a bullish direction, so having trading strategies that need a bullish trend to be profitable frequently don’t succeed.
I prefer strategies that can work in multiple trend scenarios with a well-defined risk potential. The short call spread is one of those strategies. This strategy is often called a “bear call” strategy due to the fact that is performs the best in a bearish trend and uses call options. This spread trade involves both buying and selling calls in the same option expiration series with the thesis that the underlying equity will remain stagnant or bearish during the duration of this trade. Often times traders prefer to do this trade in a very short-term way – think front month option series – so that the underlying equity will not have enough time to make a bullish advance that could cause the trade to become unprofitable. With this trade structure, the short call (the call that is sold and gives the seller the potential obligation to sell shares at the strike price of the call option) is at a lower strike price than the option that is purchased (the option giving the buyer the right to buy shares at the strike price of the call option). As you can see, this structure obligates the seller of the spread to sell shares at a lower price than the price at which he/she has the right to buy those same shares. The risk in the trade is the difference in strike prices minus the credit received when the trade is filled. The maximum potential reward in this trade is the credit generated at trade initiation.
Let’s look at a hypothetical example. Due to your fundamental, technical and sentimental analysis, you expect XYZ will have a bearish pullback in the near term. XYZ is trading at $50.00/share and technical analysis shows resistance at $52.00. You sell the Sep 2012 55.00/57.50 bear call spread for a credit of .40. What does this mean? You sell the Sep 55 call option for $1.00 and buy the 57.50 call option for $.60 generating the credit on the trade of $.40. Your risk in the trade is the difference in strike prices ( 57.50-55.00) minus the credit of .40 you received. The risk then is $2.10 per bear call. If XYZ stays at $55.00 or below through options’ expiration in September, you will keep your credit of $.40 as both options will expire completely worthless. With XYZ now at $50, this trade will work in most trends – very bearish, slightly bearish, stagnant or even a little bullish. The only trend to cause this trade to lose would be a bullish trend that takes XYZ above $55 by option’s expiration. With multiple trend possibilities providing profitability, you put the probability of success on your side. This trade example would return 19% in 6 weeks based on carrying the trade through to option’s expiration in September. No too shabby in my book for a trade with well-defined risk, good profit potential and odds of success in my favor!
By Karen Smith