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BEAR CALL SPREAD - AGAIN

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Hi Gang,

Well, I did it again. In yesterday's discussion of the bear call spread, my brain took a short vacation and I confused a few maintenance numbers. I'm so used to trading in 10-contract 10-point spreads that the numbers are just stuck in there. So, here is the article again -- with the corrections made. Hopefully, my brain is back from vacation.

Take care and trade smart,

Mike

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BEAR CALL SPREAD

Let's continue our education review with a look at the bear call spread - the other major component of our Iron Condor. The words "bear" and "call" and "spread", once again, tell us what we need to get started. "Bear" means that a bear call spread is a bearish position. "Call" simply means we're using calls and "spread" means we're using one or more options to create the position.

The Bear Call Spread is a "vertical" spread and one of the two basic components of the Iron Condor. A "vertical spread" simply means that the two options comprising the spread are both puts and they have the same expiration month.

The Bear Call Spread consists of the sale of one call option and the purchase of a second option at a higher strike price. The call option that is sold will bring in more money than the call option that is purchased - resulting in a net credit. It is thereby considered a "credit" spread. The net credit shows up in our account the very same business day.

There is a maintenance requirement on credit spreads. Your brokerage firm will hold, in your account, the difference between the strike prices multiplied by the number of contracts you're trading. For instance, if you sell the $150 call and buy the $155 call, the broker would hold $500 ($5.00 x 100 shares) per contract. A 10 contract position would require $5,000 of maintenance. The numbers, in the example below, do not include the expense of commissions.

For example: You have a short term bearish feeling about ABC Company that is trading at $145.00 with about four weeks remaining to expiration. You believe that, during this option cycle, ABC is going to remain at $145 or possibly move down in value. Below is an abbreviated option chain of the available options.

Strike Price Bid Ask
Sept. $145 call 3.50 3.80
Sept. $150 call 1.90 2.00
Sept. $155 call .90 1.00
Sept. $160 call .45 .55

Based on the above chain, let's explore a typical trade, using a 10 contract position. Remember, we're bearish. So, let's:

Sell 10 contracts of ABC Sept. 150 call @ $1.90 ($1,900)
Buy 10 contracts of ABC Sept. 155 call @ $1.00 ($1,000)
Net credit of $90 x 10 contracts = $900 ($1,900 - $1,000)
Maintenance = $500 ($5.00 difference between strikes) x 10 contracts = $5,000

We have chosen to sell the $150 call a very good reason. It's $5.00 above $145 (where ABC is currently trading). That means that ABC can actually close up $5.00 and we will still be 100% profitable. As much as stocks move around in a high volatility environment, that cushion is nice to have.

What is your break even number? ABC can close as high as $150.90 ($150 plus $.90) before you start losing money.

Even though it's possible to place this trade by first buying the $155 call and then selling the $150 call, it's much better to enter the trade as a single transaction with a net credit. The problem with trading the options separately is that the market is constantly moving. If you were to buy the $155 call for $1.00, it's very possible the market will move away in the time that it takes to learn about your fill and to send in the second order. It might move in a direction good for your cause or bad for your cause. Do you want to take that risk? I think not. Our whole trading philosophy is to avoid as much risk as possible. This is no exception.

Most good brokerage firms will have screens that allow you to input the specifics of both options and request a net credit. It's easier, cleaner and your chance of getting filled is greatly improved.

Now, let's assume that you were right. At expiration, ABC is somewhere below $150. We calculate the potential profit by dividing the profit ($900) by the amount of out of pocket risk ($4,100). The out of pocket risk is the amount being held as maintenance ($5,000) less the amount of premium taken in when the position was initiated ($900).

$900 divided by $4,100 = 21.9% return on your risk. Very acceptable for a month. But, that's if you were right. The object of the trade is for both options to expire worthless. That means you can keep the entire $900 of premium you brought in when you established the position.

What if you're wrong? You are exposed for $4,100. You're risk is defined and you'll never lose more than the $4,100. But, perhaps your analysis of the trade suggests that you should exit your position if ABC trades up to $148.50. You should check the charts to find realistic support and resistance levels before placing the trade. That will give you a bit of guidance and enable you to choose an exit point where you will close the position and minimize your loss.

When you put on a bull put spread, you are not obligated to hold the position through option expiration. You can close it at any time.

You would exit the trade the same way you enter it - trading both options in a single transaction for a net debit.

If, at some point during the option cycle, ABC moves far enough away from your bear call spread, you might be able to close the position and lock in a large percentage of the profit. If, with a week to go, ABC is trading at $135, the $150 call may only cost you a nickel or dime to buy it back. As soon as you buy it back, you are no longer exposed and your maintenance dollars (being held by the broker) are released back to you.

It doesn't make sense to be exposed to a possible catastrophic event for that last week for a nickel or dime. If you held on, you would be risking the other $.80 of premium to make that last nickel or dime. It doesn't make sense. Take the money and run.

When we trade our Iron Condors, we put on bull put spreads on indexes rather than stocks - and we try to put them on very far away OTM (out of the money). We use indexes because they are more diversified than individual stocks. If a single stock has a problem, there are hundreds of other stocks to soften the blow. An index is not as vulnerable as an individual stock.

Our objective, when trading the indexes, is to create as large a cushion as possible. Although the bear call spread is a bearish position, we want to give ourselves a lot of room to be wrong if the market is not bearish.

So, there you have it. The bear call spread and (from Thursday's column) the bull put spread. In an upcoming column we will put these two little devils together and form an Iron Condor. Stick around and see how the Iron Condor, if created properly, has a huge probability of success.




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