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Credit Spreads for a weakening market

February 11, 2007
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If I had to make a prediction, I would say that this channel on the SPX is about to be broken. MACD and Stochastic are clearly rolling over. After a week of trying to hang onto the 1450 level, the market gave up and retreated south. The 1430 level now represents the convergence of the 30 day MA, the rising support line from the Channel since November, and potential horizontal support from a recent line of resistance. Breaking that area and the recent channel would be a major red flag. Breaking below the 1420 area would be an official lower low.

The Nasdaq isn’t any prettier with what looks already like a lower high.

This weekly chart of the VIX isn’t all that scarey looking. 12.50 remains the level beyond which we know there is a major change in progress. (I’m setting an alert for my own personal, instant newsflash.) The last week of action on the VIX doesn’t look too bad, but it is noteworthy that the entire range of this weekly bar, shadows included, was made on Friday.

So it seems that at the very least, the uptrend is in jeopardy. If we are going to be headed generally sideways if not down, selling calls and doing credit spreads will be more suitable than going long stock and calls. In addition, if the market does begin to break down and VIX begins to rise, this will be accompanied by a rise in implied volatility which factors into the time value of options, making them more expensive. If they become more expensive, it is more advantageous to be an option seller.
If you have stock positions that look to be peaking or going sideways, consider selling March calls on them. Right now we’re right in that window of 20 to 40 days before expiration. This time period is where we want to be selling calls in order to capitalize on the last month and more rapid decay of their time premium. (Of course, the proper analysis must be done for each individual position and you must be comfortable with getting called out of the stock or buying back the short call early.)
But let’s talk credit spreads. In short, a credit spread is a position made of selling one option and buying another creating a hedged, defined risk position in which the net cost of the two “legs” brings in a credit. Let’s use the SPY.

If we owned the SPY, we could sell calls at 145 for $1.40. As long as the stock is not at or higher than $146.40 at March expiration, we will make more money on the position than we would on just the stock. (Note the January post in which I mentioned selling Feb 144 calls.) But what if we don’t own the stock? Sell the 145 calls naked? We could do that, but it would require a lot of margin and would theoretically have unlimited risk because the the SPY could take off like a rocket and never stop. Let’s make a credit spread out of it.

We can sell the March 145 Call $1.40 and take on the obligation to sell shares of SPY at 145 if “called out.” In order to limit our loss and define our risk, we can buy a higher strike price as a form of insurance. Since those calls at a higher strike price will cost less than the ones we sell, the net position will be a credit. I’ll choose the March 147 call which we can buy for .65.
The total position then would be a “vertical” spread, March 145/147 for a total credit of .75. It is often referred to as a “Bear-Call” Spread, because it is a bearish position that benefits from the stock going down and it is made of calls. (Bull-Put Spread is the other type over Vertical credit spread.) In the worst case scenario, the stock would fly higher than both sides of our position. In order to fulfill our obligation to sell someone the stock at 145 we could use our right from the purchased call to buy the stock at 147 no matter how high the actual stock price. This makes for a max risk of $2. But with the credit that we took in on the position, we actually are only risking $1.25. The potential return on risk here is .75/1.25=60%.

I should note that I am not going to trade this position. As the name implies, it is a bearish position(even if it makes money in a sideways market too). I am not yet bearish on the market. I think the position is actually not such a bad idea and could work out very nicely. But it’s more a matter of what kind of trader you are and how you will manage your risk and where this fits into your portfolio.

The example is more for the purpose of at least attempting to introduce the concept of a credit spread before refering to them further. I have mentioned a trade on BHI that I intend to recount for you, but felt the need to do a general intro to what a credit spread is first. Also, because people seem to be more comfortable with calls than puts, I figured it’d be best to use a call spread as an example.

What I will get into on the next post is the prospect of reversing a trade. In short, if you put on a Bear-Call Spread and then the stock or index moves very aggressively bullish, you can close the short side of the spread by buying back the 145 calls for a loss. But by keeping the 147 long calls, you would then be in a position with unlimited profit potential. In doing this, we switch our position from a bearish one to a bullish one. This should not be done flippantly. I’ll discuss further in my coming post on the BHI trade. (Sorry, I know I’ve mentioned it a number of times already and haven’t done it yet. I just don’t want to write any more at the moment.)

Be carefully out there. Choppy waters.

One Comment leave one →
  1. Jim permalink
    February 12, 2007 1:22 am

    Nice post Matthew. I have the 144/146 Feb call spread so hopefully that works out. Got .75 credit for that so it is similar to the trades you outline here. I’m definitely think of a similar position for March, the 145/147 might be a bit too conservative for me 🙂 Looking at the 144/146 again or even the 144/147 as right now at least the credit is showing as giving a breakeven above the recent high. If the sideways/down forecast proves correct, money to be made there. We’ll see.

    I’m thinking of selling the 144’s as if there is a breakdown here it would make this most recent move to new highs the outlier and 144 should be new resistance. Such is the thought… anyone want to call me out as the crack smoker I am?

    Also, aside from the potential lower high in Nasdaq, there is potential lower high in $XMI and $OEX failed to hit a higher high on the last move.

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