Lessons from the Pros

Bear (Call) at Work

In my last newsletter, "Buyers versus Casinos", I clearly stated that being a seller (casino) is profitable. Since then I have received a "hate e-mail" by an anonymous reader who completely disagrees with me without giving any reasons whatsoever. This article will lay out the arguments for the credit spreads in order to point out the fact, and not an uninformed opinion, that being a seller works quite profitably.

In order to illustrate this point, I will share one of my current credit call trades. A Bear Call is basically a vertical credit spread in which one strike price is being sold while the one above it is being bought for the same month. The sold strike price brings in more premium than the bought strike price which produces the credit. The most essential part of the trade is actually determining which strike price to sell.

Knowing which option strategy to use comes only after already having the technical analysis completed. On the day I chose to place a Bear Call spread, the chart of the QQQQ, the exchange traded fund that tracks the NASDAQ, looked identical to Figure 1.

Figure 1

It took me only a few moments to conclude that the 33 zone/area (highlighted in yellow) on the QQQQ would act as a major resistance; therefore, I selected a bearish strategy from my arsenal – Bear Call. At that time, a couple of days before Halloween, I did have a choice to make between selecting November or December expiry. I picked December due to the fact that my risk to reward ratio worked much better.

In my example, I have (Sold To Open) STO – 10 Dec 2008 33 calls @ 2.42 and also (Bought To Open) BTO + 10 Dec 2008 34 calls @ 1.91

The credit of 0.51 cents came from the difference of the two premiums which is 2.42 minus 1.91. Although the credit of fifty-one cents might not seem much, it needs to be multiplied by 10 contracts. Also, every single contract controls 100 shares; therefore, the credit of 0.51 cents turns out the credit of $510.00 without subtracting the cost of commissions.

The spread between the strike prices is 1.00 (Meaning 34 strike price minus 33 strike price gives us 1.00)

Maximum loss is calculated by subtracting the credit received (0.51) from the width of the spread; in other words, 1.00 minus 0.51 equal 0.49. Therefore, as long as a trader has $490.00 in his account, he or she would be able to place that trade.

The reward of 0.51 divided by the risk of 0.49 gives a 104% return on our money.

Figure 2

Figure 2 illustrates the day and time I performed this transaction in my brokerage account and received the credit of 0.51 cents times 10 contracts. The money would show up in the account but it would be placed in parentheses, because it really becomes mine only after the expiry.

Figure 3

Figure 3 illustrates that currently both of the calls are nearly worthless with only a couple more days left before the expiry. The decrease in premium should also be visible in the chart.

Figure 4

At the time of writing this article, the QQQQ was trading around 30.00 and the sold strike price was still quite a distance away, sitting at 33. In this case, both of my calls, the one that was sold and the other one that was bought for protection, will expire worthless, which means that I paid only two commissions; those two commissions were the ones that I paid at the entry and none needs to be paid at the end when the current price is so far removed from the sold strike price. The QQQQ is at the 30-ish level, while the sold one is at 33.

In conclusion, Bear Call, or being a seller of the premium in general, works as long as a trader is correct on his or her technical analysis. The credit spreads aren’t meant to be a type of trade as place-it-and-forget-about-it. The credit spreads DO need to be monitored and if things go wrong then the sold strike price, also known as the obligation, needs to be purchased back.

An advantage of spread trading is the clearly defined risk and also at the same time, the unmistakably defined reward. Those are the facts of a Bear Call trade that netted $510, and I hope this newsletter clears up any confusion about the details. Once again, those who sell premium last. Casinos are going to outlive all of us; therefore, be a seller of premium with a good knowledge of technical analysis. Good trading.

- Josip Causic

jcausic@tradingacademy.com