Call Credit Spreads for a Non-Bullish Environment

What does an option trader do if he or she thinks an underlying most likely won’t go higher but doesn’t feel confident it will drop much either? It is hard to profit in that scenario, but by using options you have the potential to do so.

Call credit spreads (bear call spreads) can be an effective way to profit when the option trader expects the stock to stay below a certain area. Many times this area is potential resistance in the form of pivot levels or maybe a moving average. In addition, maybe the overall market and/or the underlying looks less bullish. Let’s look at how this trade strategy can be implemented.

A call credit spread, or as it is sometimes called a bear call spread, is created by selling a call option and buying a higher strike call with the same expiration. Maximum profit is the credit received and it would be earned if the options expire worthless (at or below the short strike at expiration). The maximum risk on the trade is subtracting the premium received from the difference in the strikes. The breakeven point is adding the credit received to the short strike. Let’s take a quick look at a recent potential opportunity where a bear call might have been considered.

When Visa Inc. (V) was trading around the $186 level in November, the chart looked like this (see below).

At the time, there were some pivot levels that had acted like resistance around the $190 level and the daily 200-day moving average. The stock might have a difficult time closing back above that level especially if the trend continued lower. A 190/195 bear call spread with less than a week to go until expiration could have been sold for about 1.34 (2.25 – 0.91).

The $1.34 (or $134 in real terms) represents the maximum profit that could have been earned if the stock stayed at or below the $190 level at expiration. The maximum risk was $3.66 (5 (difference in the strikes – 1.34 (premium)) or $366 in real terms) if the stock closed at $195 or higher at expiration. Breakeven would be at $191.34 (190 + 1.34 (premium)) at expiration.

The stock could move lower, trade sideways or rally up to $190 by expiration with the maximum profit still being earned and the options expiring worthless. That gives the trade three out of four ways to potentially profit. As everything in option trading, there are risk/reward trade-offs. The trader is risking a lot more than the profit potential, but that comes with a high probability of success.

John Kmiecik, Market Taker Mentoring

Trader Education