It’s common knowledge that the market goes down much faster than it goes up.
That’s because, for the most part, people are Long the stock market.
And when the market tanks, there is panic selling, which leads to the market crashing.
So if you use the right Option strategy, you can make profits much quicker on a down move than on an up move.
And there’s no better Option strategy to do that than the Bear Call Spread (aka Short Call Spread).
The Bear Call Spread is a neutral-to-bearish Option strategy that seeks to profit if the market goes down, sideways, or even if the market goes up a little.
It is also a good way to hedge a Long stock portfolio.
So what exactly is the Bear Call Spread and how do you trade it profitably?
The Bear Call Spread Strategy (Call Credit Spread)
The Bear Call Spread is one of the two popular Credit Spreads (the other is the Bull Put Spread).
This strategy consists of two Options:
- A Short Call (usually out-of-the-money (OTM)).
- A Long Call (further OTM).
And the distance between the two strikes is called the width of the spread.
By design, this is a defined-risk strategy.
That means the maximum risk has already been capped on entry and you can’t lose more than what you risk for the trade.
So for example, if the spread of the width is $5 and you received $1.50 in premium, your maximum risk would be $5 minus $1.50 which equals $3.50.
That would mean your maximum loss on this trade is $350 per spread (one short call and one long call).
So even if the stock goes way above your long call strike price, the most you can lose is $350.
That is why this strategy is very suitable for new Option traders and those with small accounts.
Now, if you come from the traditional world of trading where you can only Long or Short stocks, you will notice that this risk-to-reward ratio is that favorable.
You’re risking $3.5 to make $1.50.
That means for every loss, you’d need to make at least three winners to be profitable.
So how are you able to be profitable in the long run?
How To Be Profitable Trading The Bear Call Spread
While your risk-to-reward ratio may not be favorable, you are actually compensated with a high win rate.
That means that you will win more often than not with this strategy.
The image above shows a $5 wide Bear Call Spread on the SPY Index ETF.
At the bottom-left of the image above, you will notice it shows “POP 71%”.
POP stands for Probability of Profit.
In other words, the win rate of this strategy.
And the premium collected for this is $150.
So the maximum loss will be $350.
Now, if we were to calculate the expectancy just based on these numbers, we get:
(Win Rate x Max Profit) – (Loss Rate x Max Loss)
= (71% x $150) – (29% x $350)
= $5
That means to say that every time we put on this trade, we expect it to make $5 in the long run.
So this is a positive expectancy strategy.
But how can we further put the odds in our favor and generate an even higher positive expectancy number?
By implementing 3 key criteria to boost our winning percentage.
3 Key Criteria To Increase Probability of Profit
Although we know that the Bear Call Spread is profitable, we still want to be selective on when we put on the trade instead of putting it on randomly.
So here are 3 key criteria to help you further put the odds in your favor when trading the Bear Call Spread.
Key Criteria #1: Wait till the market is overbought.
At any time, the market will be in one of three market conditions:
- Oversold
- Neutral / going sideways
- Overbought
If you were to put on a bearish strategy like the Bear Call Spread, would you rather put on the trade when the market is oversold, going sideways, or overbought?
It would be when the market is overbought because then there would be an increased chance that the market would start reversing back then.
So to identify what condition the market is in, we use either the Stochastic Oscillator indicator or the Relative Strength Index (RSI) indicator.
Key Criteria #2: Place the Bear Call Spread above a resistance level.
Resistance areas are where the price has shown that there is some selling pressure.
That means that the market is less likely to go above these resistance areas compared to other areas on the chart.
That is why ideally, we want to place our Bear Call Spread below these resistance areas.
This way if the market goes up to the resistance area, there’s a chance it would reverse back down if it fails to break the resistance levels.
Key Criteria #3: Short leg of the Bear Call Spread is around 20 – 30 deltas.
While the definition of delta is the “theoretical estimate of how much an option’s value may change given a $1 move up or down in the underlying security”, it can also be used as a rough estimate of the Probability of Profit (POP).
For example, 30 deltas would approximately be a theoretical 70% POP, and 20 deltas would approximately be a theoretical 80% POP.
However, we don’t want to go lesser than 20 deltas because we won’t get enough premium for the risk we’re taking on the spread.
So how do you implement these 3 key criteria?
7 Steps to A Winning Bear Call Spread Setup
Step 1: Wait till the Stochastic Oscillator shows an overbought condition in a downtrend.
Step 2: Identify the previous Resistance Level (previous high).
Step 3: Go to the Options Chain and look for the options that are in the 30 – 60 DTE.
Step 4: Find a strike that is ABOVE the previous Resistance Level.
Step 5: See if the strike is within 20 – 30 Delta. If not, wait till the market goes higher (and becomes more overbought).
Step 6: If the strike is within 20 – 30 deltas, construct the Bear Call Spread and see if you can get at least $1.00 – $1.50 premium (for a $5 wide spread), or at least $2.00 – $3.00 premium (for a $10 wide spread).
Step 7: If you’re satisfied with the premium received, place the trade and manage the trade accordingly.
Here’s a trade example to show you how it’s done.
The first step is to look at the Stochastic Oscillator to see if it’s showing an overbought market condition.
As you can see on the right-hand side of the chart, the Stochastic Oscillator is indeed showing an oversold signal.
The next step is to identify a resistance level above the current price.
And as you can see on the chart, there is a resistance level at $411.73 which is above the current price.
So what we want is to find the Option strikes that are above $411.73.
This is where you go to the Options Chain and identify the strike prices in the range of the 30 – 60 DTE Options.
In this trade, we were able to go with the 45 DTE Options.
And there are two Bear Call Spread constructs that we can go with where the short strike is around 20 – 30 deltas.
The first option is the 415/420 Bear Call Spread which gives us a premium of $1.44.
This is within the range of $1.00 to $1.50 in premium, so we can certainly go ahead with this trade if we want to.
The second option is the 420/425 Bear Call Spread which gives us a premium of $1.11.
This is slightly more conservative than the 415/420 Bear Call Spread because the strikes are higher.
That means it’s harder for the price to reach there and hence a higher POP.
And the premium of $1.11 is also within the range of $1.00 to $1.50.
So we can certainly go ahead with this trade as well.
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