Part of a Bear Credit Spread.
There was another nice piece in the IVolatility Trading Digest this morning, that talks about how to set up the spread scanner to search for credit spreads.
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First we should explain bearish call credit spreads and what we are intending to accomplish. This is an Income Strategy that sells calls and protects the downside by buying the same number of calls with a higher strike price in the same expiration month. It is a limited risk and limited reward strategy. To ensure best results ideally both of the call strike prices should be out -of- the- money (OTM). As a practical matter we will have to accept a bit more risk by selling at- the- money (ATM) calls or we would not find many opportunities. The spread is done for a credit as the ATM calls are higher priced than the OTM calls bought for protection.
If the stock falls as expected then both calls will expire worthless and you retain the credit generated when the position was established. If however, the stock rises the break-even price is the lower strike price (the call sold), plus the net credit. The maximum loss is the difference in the strike prices, less the credit received. Set the Stop/Unwind (SU) at the break-even and buy back the short call, if the stock is gaining momentum or unwind the position if the stock price changes are erratic.
Since we are seeking a stock that will decline in price we need to consider if the market conditions support our assumption. We are expecting the S&P 500 Index to decline further so this would be consistent with the plan. We would want to exclude stocks in the consumer staple group as they have a tendency to decline less than the consumer discretionary stocks. We would want to exclude stocks in the groups that are showing relative strength, such as Agriculture and Mining. Finally we would want to exclude those that are potential takeover targets, such as YHOO and perhaps VCLK. The very best choices would be stocks that have just completed a counter-trend short term rally and are now resuming their longer-term downtrend.
The setting for the IVolatility.com Spread Scanner, using Friday's closing data are:
Position Selection
Sell Mar08 Call, ATM.
Buy Mar08 Call OTM15%.
Position Criteria
Position IV ratio min. 1.25, max. Undefined.
Position cost Credit min. .75, max. Undefined.
Stock Selection
All USA.
Stock price min. 20, max. 100.
Option Volume 1000.
Options OI (Open Interest) 2000.
Show 50 records per page.
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I'll be experimenting with this tool more in the future. Right now, limited risk appeals to me.