Yesterday I discussed in great detail one of my favorite options strategies, the bear call spread.
Today I’m going to reveal a specific trade based on this strategy, but for more detailed information, I urge you to attend my free event this week.
You should attend because in my live event on options strategies, I’ll reveal three free trades that could add $247 to your account – and these trades are examples of the kinds of trades professional options traders use in their own accounts.
So, with that being said on options strategies, I’m not going to retrace the basics of the strategy. Instead, I want to dig further into the strategy by discussing a potential trading opportunity.
As you can see in the S&P 500 ETF (NYSE: SPY) chart below, the fund has pushed significantly higher over the past few weeks. As a result, the RSI (2) and RSI (5) are in an “overbought” state.
When this type of short-term move occurs, mean reversion – the tendency for a stock to return to its average price – usually kicks in. In this case, SPY has moved several standard deviations away from the mean.
Think about a “very overbought” move in terms of the standard bell curve. When something is “very overbought,” it has moved to the outer fringes of the curve.
Just a few weeks ago, there was only a 7.37% chance that SPY would push to where it’s trading now. The options market, as seen in the options chain for SPY below, stated that there was a 96.31% probability of success that SPY would close on February below $234.50.
So, we know the move is somewhat of an anomaly.
When a move like this occurs and we see RSI push to “overbought” levels, I immediately want to fade the directional move. When I fade a move – in this case a bullish move – I am hoping for a short-term reprieve in the underlying price. The price could move lower, trade sideways or simply plod slowly higher. I’m just hoping for the laws of mean reversion to kick in.
But I increase my pot odds by wrapping a high-probability strategy around the trade. Rather than take a directional bias and simply buy puts, I want to sell calls, more specifically bear call spreads.
In this case, since SPY is currently trading for $234.72, I want to sell a call at a higher strike. But which strike? I always start my search with the strike that has an 75% probability of success, preferably over 80%. What that means is that at expiration in 43 days, there will be at least a 75% chance that SPY will close below that strike.
As you can see from the option chains above, the 239 strike meets my requirements.
We can sell the 239 call strike and buy the 241 strike for a net credit of $0.42.
Our return on the trade: 26.6%.
Basically, as long as SPY stays below our short strike at expiration we will reap the entire premium of 26.6%. There is a 76.44% probability of success that the price of SPY will stay below our short call strike of $239 at expiration in 43 days.
But don’t forget, we are wrapping a high-probability short-term trade on an ETF that has already pushed into a “very overbought” reading. This increases our pot odds on the trade that much further and it’s why I’m not placing trades every other day. It’s a methodical, patient approach.
These are odds that I like to see in a trade. I hope you agree. If so, make sure you check out my upcoming webinar on how I use vertical call and put spreads for consistent income.
I’ll share live trades, and as always, I’ll include an extensive Q&A to clear up any questions about this strategy.