Option Investor
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Bear Call Spread Revisited

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OOPS! The law of probability says that some trades are bound to get off to a rocky start. We talked last week about bear call spreads using IBM as an example, which clearly fits that bill. We want the price moving down in order to profit from our spread, but the price is moving up! Panic - we're stuck!

OK, let's take a deep breath and clear our minds for minute from that unavoidable sinking feeling when a trade moves against us. It isn't as bad as we think as long as we keep a clear, cool head.

In essence, we're going to examine the trade again to determine that age-old traders' question (with apologies to The Clash from 1982), "Should I stay or should I go?"

Here's a recap of where we left off. We had opened a bear call credit spread:

IBM-KM NOV 65 = $8.10 bid - short
IBM-KO NOV 75 = $1.80 ask - long

Net credit = $6.30 in our pocket.

$6.30 was our maximum potential reward for IBM closing under $65 by November expiration. Our maximum risk of loss would be $3.70 if IBM closed $75 or over at November expiration. We entered this with IBM trading at about $72.

IBM trades at nearly $79 today. Thus, the trade has run against us. And that panic, fretting and fear of loss starts running wild in our brains. Maybe we're even losing sleep over it.

OK, put the brakes on those thoughts. It's time to collect ourselves. I remember reading probably 11 years ago a passage in the book, "The 7 Habits of Highly Effective People" by Steven Covey. It was a helpful book, by the way, in that it really encourages us to focus most on the "Important, Not Urgent" aspects of our lives. It all boiled down to a simple concept, "Begin with the end in mind". Something like writing our epitaphs and then doing the things with our lives that would enable those words to be placed on our tombstones and to have nice things said about us in eulogy.

Beginning with end in mind is exactly how we should enter every trade. "Great Buzz, you big smart aleck. The end I had in mind was to make a profit, and it aint here yet!" I know, but that's not what I mean. One of the basic rules of trading is that we always know our entry and exit BEFORE we ever enter the trade. And before we know that, we have to have REASONS WHY we're entering the trade in the first place.

Let's recap - we entered this trade having evaluated risk and reward and determined that the risk of $3.70 was worth the reward of $6.30. We looked at the charts and decided that IBM was nearing resistance and that a price move to $75 might make the ideal entry. Most importantly, we interested in the likelihood of collapsing volatility premium and time decay that would both work in our favor on this play even as we slept. Our most important factor - volatility and time decay - are still very much intact. Our risk and reward are still quantifiable, as exactly as they were last week. Also, we still have time to be right and let the oscillators do their job. While the price has moved against us, the principles guiding the trade are coming true.

So just how far under water have we gone? Well, at $79, we're subject to the extent of maximum risk penalty of $3.70. This is where a personal decision has to be made. Perhaps we can exit the trade early and avoid losing the whole $3.70. As I write this, IBM trades at $79.09. In order to close the position, we would have to buy back the short NOV65 call and sell back the NOV75 call. The NOV65 costs $14.40. We can get $5.10 for our NOV75 call. That would cost us $9.30 net. But remember, we have a $6.30 credit from opening the position to offset that. $9.30 cost minus a $6.30 credit equals a net $3.00 loss. We can book that $3 loss, or "roll the dice" and maybe or maybe not lose the whole $3.70. That's a personal choice we each have to make.

My personal thinking goes back to the recap of two paragraphs above. I remember why I entered this trade. I remember the risk I committed to taking - $3.70 worth. I was willing to live with that possible outcome, and I still am because other than price, the trade still stands on the principles in which it was entered. This may sound harsh, and not very touchy-feely. But those who have switched their "feelings" about the trade and have now decided that risking $3.70 is no longer acceptable should evaluated their risk tolerance BEFORE entering the trade. That emotional change of heart based on fear of loss will prove deadly to an attempted long-term career as a trader.

The point is to remember that we took a calculated risk to enter the trade, and if those principles still apply, we stick with it. Please don't misunderstand. Our job in the trade is not to "take the pain" and hope to be right. Our job is to enter initially or stay out based on our own determination of risk and reward. We make the decision to stay or go before we ever enter the trade. Better to have stayed out on unwillingness to lose $3.70 than change the strategy and lock in the $3 loss. In other words, we stick to the plan on principle than change it on emotion.

All that said, what could we do from here? Any change we might salvage the play? The answer depends a lot on risk profile and our willingness to guarantee a $3 loss, limit loss to $3.70 by staying the course, or assuming more risk and potentially reaping reward. We must decide where we stand and "know thyself".

Each branch of that decision tree must be evaluated. The first two, we've already evaluated. Assuming more risk is really a separate trade and should be evaluated completely independently of the position we already hold, If we are thinking, "Great, an opportunity to make up for our loss", we are dead meat. That's a dangerous emotion belonging to a gambler. It must be evaluate as a fresh trade.

So let's evaluate starting with the chart.

IBM chart - IBM (weekly/daily/60):

Well, $75 resistance was broken and $80 is looking like a formidable next stop of resistance. We can see that on the weekly chart, as well as the weekly stochastic entering overbought. Take a look at the daily too. Notice the overbought stochastic on both the 10 and 5 period lookbacks. Just to keep it interesting, I threw on a volume chart, as well. Notice that volume increased during the selling that started in late September and volume began declining on the recent advance from early October. We note the 60 chart is also peaking just under $80 and candle action is beginning to weaken as the stochastics have lost their "oomph" in the thin air around the current price.

This still looks like a great short candidate to me, only this time with a better entry. Were I going to enter another bear call spread, shorting the $75 call ($5.00) and going long the $85 call ($0.50) yields would yield a $4.50 credit. But that leaves $5.50 of risk. Too much risk and not enough reward for my taste this time around.

But there is another factor missing here too. Volatility isn't as great as it was a week ago, which reminds me that I don't have quite as much to gain from a volatility collapse. Personally, I think a volatility collapse back under 30 is unlikely for the current option cycle. For this reason, I'd personally rule out entering a new 75/85 bear call spread.

What to do? Let's see, volatility is down slightly; DEC contracts would have even less volatility in the put option prices, which leaves more time to be right. You know, I might just consider buying straight puts this time around.

Of course, there are no guarantees, but this looks to me like an even better entry if we are to bet on future declines in IBM. Not only that, but we may yet be right on the first bear call spread for all the right reasons.

Make a great weekend for yourselves! Happy Halloween!


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