Last week I discussed in great detail one of my favorite options strategies, the bear call spread.
So, with that being said, 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 Powershares Nasdaq 100 (Nasdaq: QQQ) chart below, the QQQ 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, QQQ 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 4.88% chance that QQQ would push to where it’s trading now. The options market, as seen in the options chain for QQQ below, stated that there was a 97.62% probability of success that QQQ would close on July 8 below $109.
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 QQQ is currently trading for $109.72, 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 42 days, there will be at least a 75% chance that QQQ will close below that strike.
As you can see from the option chains above, the 113 strike meets my requirements.
We can sell the 113 call strike and buy the 115 strike for a net credit of $0.42. To find the credit, take the bid price of the 113 strike we sold ($0.65) and subtract the ask price from the 115 strike we bought ($0.23).
Our return on the trade: 26.6%.
Basically, as long as QQQ stays below our short strike at expiration we will reap the entire premium of 26.6%. There is a 76.63% probability of success that the price of QQQ will stay below our short call strike of $113 at expiration in 42 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.
More importantly, it’s an approach that has led to 11 straight winning trades in my Verticals Portfolio for my Options Advantage service.
These are odds that I like to see in a trade. I hope you agree. If so, make sure you check out my latest webinar on bear call spreads and options strategies.
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