This is important. I’ve discussed numerous times, in great detail, one of my favorite option strategies, the bear call spread.
So, with that said, I’m not going to go over the basics of the bear call spread strategy. Instead, I want to dig further into the strategy by discussing the mechanics and why it has led to a win ratio of 90.9% (20 out of 22 winning trades) for a total cumulative return of 332.7%. That’s a consistent average return per trade of 15.1%.
As you can see in the iShares Russell 2000 ETF (IWM) chart below, IWM pushed significantly higher over the past several weeks. As a result, the RSI (2) and RSI (5) hit a “very 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, IWM 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.
There was only a 10.76% chance that IWM would push to where it’s trading now. The options market, as seen in the options chain for IWM below, stated that there was an 89.24% probability of success that IWM would close on June 22 below $168.
So, we know the move is somewhat of an anomaly.
When a move like this occurs and we see RSI push to “very 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 the bear call spread.
In this case, since IWM was trading for $170.15, I want to sell a call at a higher strike. But which strike? I always start my search with the strike that has an 80% probability of success. But in this case, we are in a very overbought state and I only want to be in the trade for a few days. What this means is that I am going to go with a trade that has a lower probability of success.
We can sell the 172 call strike and buy the 174 strike for a net credit of $0.66.
Our return on the trade: 49.3%.
But I don’t plan on holding the trade for the entire 30 days. I will get out as soon as IWM pushes immediately lower for a return of 15% to 20%, on average.
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.
If you wish to learn more about my trading process on my weekly bear call trades or my monthly bear call spreads and how I’ve made total returns over 332% in the first six months of 2018, please make sure to sign up for my upcoming webinar on Tuesday, June 26 at noon Eastern Time.