Preparing For A Potential Market Decline

September 21, 2013
By Vlad Karpel

The Power Of A Bear Call Spread

The current year has been very profitable in terms of stock market investment. Although there is are still over three months left to go, the S&P 500 is already rising around 19%. However , three months is plenty of time for the market to go even higher. On the other hand,  it is also enough time for the bears to take control of the market  and steal the smile many investors now have.

At Trade Spoon, we decided to collect some data in order to have a better idea about the relationship between a strong first half performance and the subsequent second half performance. We wanted to find out whether or not there is a  substantial connection between them. We also wanted to observe if the first half performance could give any  insights into the second half.

We ranked the data from the first half by performance from highest to lowest.  Then we split the numbers into sub-groups. We found that the second half performance tends to continue in the direction of first half when the first half is really strong. However, the upward trend follows with much less strength. The explanation may be that as the market rises, many investors take profits and go out. However, other investors are seduced by the huge observed returns, which guarantee the continued trend.Unfortunately, as others take profits, markets lose some of their strength.

This year, the S&P 500 closed the first half with a 12.6% rise and added a few more points. Now it is rising by 19%. We have concluded  from looking at the numbers and historical data that it may be time to protect our first half profits by changing the strategy to one more bearish.  To accomplish this goal we can use the power of a credit spread. In this case, we will specifically want the bear call spread.

How to set up the strategy

A bear call spread involves buying and selling the same number of call options for the same maturity date. It is a vertical spread because what varies between the options is the strike price rather than the time horizon. The simplest way to build this strategy is to buy one call while selling another. What must always happen is: the shorted call must have a lower strike (should be more in-the-money). This way you will receive a credit for the strategy, as the option you buy is cheaper than the one that you sell.

Usually this strategy involves buying an out-of-the-money call while selling an in-the-money call. However, as long as you respect the rule of strikes that was mentioned above, it doesn’t have to be that way. In fact, for our goal the best strategy involves using two out-of-the-money call options. This is because we believe the market may either decline or go a little higher. When using two out-of-the-money options, we give more margin for a S&P 500 rise while keeping profits from the trade. Let’s take a look at an example.

Consider that the S&P 500 was trading at 1,685 and that the following options are available to trade:

  • Call with strike 1,710 @ $21.20
  • Call with strike 1,670 @ $43.00
  • Call with strike 1,780 @ $3.00
  • Call with strike 1,750 @ $4.80

These call options are all expiring in 45 days time.

If you believe the index of S&P 500 will rise moderately at most, then you may prefer to sell an out-of-the-money option. For this, the option with strike 1,750 fits perfectly. With the S&P 500 trading at 1,685, you have a margin of 65 points. To complete the trade, you should buy the 1,780 call. This strategy will give you a net credit of $4.80. Instead of paying, you will receive cash.

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Maximum profit occurs if the shorted option expires and becomes worthless, which happens if the S&P 500 closes below 1,750. In that case, profit will be exactly equal to the initial net credit, or $4.80. If the S&P 500 rises above 1,750, profit starts declining. We have a cushion of $4.80, meaning that when S&P 500 reaches 1,754.80, the strategy reaches breakeven. Above that level we start losing money. This can amount up to a maximum loss reached at the strike price of the long call. Above that price, one call cancels the other and our loss is equal to the difference between the strikes minus the net credit received.

The following table summarizes three different strategies. The first is a naked call, a strategy involving just shorting a call without protecting with a long call. The second strategy is a bear call spread involving buying an out-of-the-money call but shorting an in-the-money call. This is less bearish than a naked (written) call but still more bearish than the third strategy, which is the one we depicted above.

CHART

The bear call 2 is the strategy with the highest probability of giving you a profit. This comes at the cost of reduced potential profit in relation to maximum risk. Nevertheless, for the aim of profiting from an S&P deceleration, this strategy leads to a maximum profit of $4.80 for a risk of $25.20. That’s a more than decent profit, given that you end in the green, which will happen as long as S&P 500 don’t rise more than 4.14%.

The following table shows the interaction between the strategies.

CHART 2

The chart clearly shows that the naked call is the strategy providing higher potential profit, but it comes at the cost of unlimited risk. The bear call 2 reduces potential profit but effectively shifts breakeven to the right in the chart, giving the trader an extra cushion just in case the underlying asset rises a little.

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