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REAL-WORLD TRADING: Using a Bear Call Spread, Part III

By Jody Osborne, Optionetics.com | Mon February 14, 2005 5:00PM PT


A few weeks back we started a series of articles discussing a bear call spread. Last week, we picked a stock to enter a mock trade on. The stock we chose was Total SA (TOT), an oil exploration company. Before we go into what has happened this past week, let’s first review this mock trade.

We picked TOT because the stock had strong resistance at the 110 level, while the stock was trading near 109. The stock also showed a bearish candlestick pattern last week, which we felt would keep the stock below 110 until expiration in March. Below is the data for this trade when we entered it.

02/07/2005
TOT @ 108.83
110-115 Bear Call Spread
Sell 5 Mar 110 calls @ 1.65
Buy 5 Mar 115 calls @ 0.45
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

This looked good, as TOT shares would have to move nearly $2.50 higher for us to lose money on this trade. However, we set up our exit point at 111.00 on the stock, as this would be a new 52-week high. Unfortunately, this occurred Monday, which means we would have wanted to get out of the trade. Below is the data as of the close on Monday.

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Current Loss = 1.05 or $525
Net Credit = $600
Max Risk = $1900
Breakeven = 111.20

The stock closed last Friday just below our exit point, but strength Monday pushed the stock through our exit point. Using the closing prices on Monday, we get the data from above. However, if we were to have gotten out closer to $111, we could have gotten out for a little less. So, if we were to close this trade here, the loss would be $525. We hate to see losses, but we also like to cut losses short. Because we expect to win two thirds of the time with a credit spread, we can live with a loss that is less than our max reward.

Even though we would have gotten out on the move through $111, I want to continue following this trade using an adjustment. By adding a bull put spread onto this trade, we can lessen our overall max risk a bit, while raising our possible reward. The catch is that the stock will have to stay in a smaller range in order to profit. Here is a risk graph of this adjustment:


Figure 1: Risk Graph of Adjustment

What we have done is add a bull put spread by selling the 110 puts and buying the 105 puts for $0.95 or $475. This raises our credit to $1,075, with a max risk of $1,430.  

02/14/2005
TOT @ 111.38
110-115 Bear Call Spread Adjustment
Add a 110-115 Bull Put Spread
Buy 5 Mar 105 puts @ 0.35
Sell 5 Mar 110 puts @ 1.30
5 Mar 110 calls @ 2.95 (ask)
5 Mar 115 calls @ 0.70 (bid)
Net Credit = $1075
Max Risk = $1430
Upside Breakeven = 112.15
Downside Breakeven = 107.85
Current Loss = $575 (getting inside the spread)

By holding a combination of a bull put spread and a bear call spread, we have created an iron butterfly. Thus, each day the stock stays in this range, our gains will increase. The risk still is a sharp move, but now it could occur in either direction and we would experience a loss. With earnings coming up Thursday, this risk is legitimate, but we’ll follow the trade to show how this adjustment works.

Where to set a stop loss now is a personal decision, but I don’t want to lose more than I can make, so I would set mine at a loss of $1,000 for this trade. Using the What If? Tool, we see that in the near term, this means the stock needs to stay between 104 and 116. 


Figure 2: What If? Table

We’ll update this trade next week, until then, try different adjustments in Platinum to see what sort of trades could be created. This is how new strategies develop over time. Please feel free to ask question and post your findings on my forum.

To read previous installments of Real-World Trading, please click here.


Jody Osborne

Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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Recent articles by Jody Osborne, Optionetics.com


December 03, 2010  -  Economic Watchdog, Dec 3
December 03, 2010  -  Closing Wrap-Up, December 3
December 03, 2010  -  Morning Watch, December 3
December 02, 2010  -  Economic Watchdog, Dec 2
December 02, 2010  -  Closing Wrap-Up, December 2


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