Play the Selling Sequel with Call Spreads

by Tyler Craig | April 12, 2012 1:13 pm

Traders anticipating a sequel to the Monday-Tuesday swoon should be viewing the current market rally as a shorting opportunity. Though buying dips has been the name of the game for the last four months, the recent break of the 50-day moving average in the S&P 500 Index (SPX[1]) may be signaling the transition into a range-bound environment where selling rallies becomes more lucrative.

One option strategy that should do well under such conditions is the bear call spread. Sometimes referred to as selling a call vertical spread, the position consists of selling to open a lower-strike call while buying to open a higher-strike call in the same expiration month.Daily chart of SPY
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Traders typically use out-of-the-money options to structure the trade with a wide profit range. In addition, shorter-term options are typically used to exploit the higher rate of time decay.

The spread is entered for a net credit, which represents the maximum reward available and will be captured if the calls expire out-of-the-money. The max risk is limited to the distance between strike prices minus the net credit collected and will be incurred if the underlying stock is trading above the higher strike price when the traded options expire.

By providing the ability to profit even in neutral environments, the bear call spread acts as a higher-probability alternative to shorting stock or buying puts outright.

While the SPDR S&P 500 ETF (NYSE:SPY[2]) may yet rally for another day or two, suppose we look at selling the May 143-148 call spread once the buying pressure abates and a new down leg begins. If sold around the current price of 72 cents (selling the 143 strike, buying the 148 strike), the spread offers a max reward of $72, which represents a 17% return on the potential risk in the trade ($427).

Think of the play as a bet that the SPY won’t rise above $143 over the next month through May options expiration. From current levels, that’s a move of roughly 3.2%.

Of course, if the current bounce in the SPY takes the ETF higher than expected, traders might consider using call strikes above $143 if there is sufficient premium to be collected.

At the time of this writing, Tyler Craig had no positions on SPY.

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