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Another trading opportunity has presented itself to us and I want to show you, step-by-step, how I approach the scenario.
As you can see in the chart below, the SPDR Energy ETF (XLE) has been pushing higher over the short-term. Both the RSI (2) and RSI (5) are in a short-term “overbought” state.
(Remember that RSI – the Relative Strength Index – is simply a measure of price action indicating momentum. A high RSI (above 80) means something that has risen quickly and could be due for a pullback. Visa versa, a low RSI (below 20) means something has fallen quickly and could be due for a correction to the upside.)
So, the question is, what’s my approach? When we see the market, more specifically XLE, hit an overbought state knowing that mean-reversion often occurs, what’s my strategy of choice?
In this case, I use what’s known as a bear call spread – or vertical call spread.
It’s probably the most common trading strategy in my arsenal of options selling tools for a variety of reasons:
- I believe the market doesn’t crash higher; it crashes lower.
- The strategy allows me to have a margin of error just in case my directional assumptions are wrong.
- I can define my own risk/reward at order entry.
- Basically, I have the ability to choose my own probability of success on the trade.
- Of course, the higher the probability, the more I stand to lose. But again, I have the ability to define my risk, through proper position sizing, at order entry.
How does this strategy work?
In short, I’m using two different trades to earn income from the likelihood that XLE will not rise another 3%.
Trading Strategy: SPDR Energy (XLE)
- I sell a call at $74 (which is $2.16 higher than XLE is in this example). We expect XLE to fall from here – but we’re giving ourselves a 3% cushion.
- Then I simultaneously buy a call at $76 (which goes up in value if XLE rises in price.)
The only way we lose money is if XLE rises significantly above $74 by late October. My worst case scenario is if XLE rises above $76. The $76 call acts as a stop-loss for this trade because no matter how far above $76 XLE rises, the loss is capped there.
As long as XLE stays below the 74 strike at expiration in 43 days I have the ability to reap a max return of 24.2%. If it rises above $76, we’ll have a max loss of 75.8%. Realistically, it’s going to be slightly less time, because I prefer to buy the spread back before expiration to lock in profits, take off risk and afford myself the opportunity to sell more premium.
Bear call spreads are not new to the world of investing. Unfortunately, not enough investors are aware of this sound options strategy which provides reasonable expectations for returns. Most investors are only exposed to the long-side of the market. Options, more specifically vertical spreads, allow even the most novice investors a chance to reduce risk and volatility in their respective portfolios.
If you would like to know more about my vertical spreads trading strategy, please sign up for my free webinar on Tuesday, Sept. 13 at 12 p.m. ET. I’ll discuss, in detail, how to effectively use vertical spread in a variety of market environments, plus field all of your options-related questions in an extended Q-and-A session.
If you can’t make it, no worries. Just sign up and I will send you a replay shortly after the event.