Trade Idea: Learn How to Trade a Bear Call Credit Spread on IWM

Trade Idea: Learn How to Trade a Bear Credit Spread on IWM

A few weeks ago, I posted a “Trade Idea” using a bear call spread in the SPDR S&P 500 ETF (SPY).

On August 23, 2021, we went over a trade example in SPY selling the October 15, 2021 463/468 bear call spread for $0.87. The probability of success on the trade was 81.46% with SPY trading for 448.17.

Now, with 32 days left until expiration, SPY trades just $4 lower at 444.17. But the probability of success stands at 91.81% and the bear call spread is worth $0.32.

I’m able to lock in $0.55 or 63.2% of the original premium sold ($0.87) for a total return of 12.4%. With 32 days left until expiration, I might choose to buy back half of my trade for a 12.4% return and hold on to the other half for potentially greater profits. Or I can choose to simply get out of the trade, lock in a nice 12.4% in just over two weeks and immediately sell more premium.

In my opinion, bear call spreads are a good strategy for this market environment. Volatility is at a decent level for selling premium. Plus, with a bear call spread I have a decent margin of error just in case the stock or ETF pushes higher. If it pushes lower, particularly immediately, I should be able to lock in another quick gain.

Here is another trade idea using a bear call spread, this time in the iShares Russell 2000 ETF (IWM).

The Trade

With the Russell 2000 (IWM) trading for 226.68 I want to place a short-term bear call spread going out 32 days. My intent is to take off the trade well before the October 15, 2021 expiration date. For this trade, my preference is to go with a trade that has around an 80% to 85% probability of success.

 

IWM-stock-charts-September-13-2021

The Trade

Let’s start by taking a look at the options chain for IWM with 32 days until expiration. Once we choose our expiration cycle (it will differ in duration depending on outlook and strategy), we begin the process of looking for a call strike within the October 15, 2021 expiration cycle that has over an 80% probability of success. If you don’t have access to probabilities of success on your trading platform look towards the delta. Without going into too much detail, look for a call strike that has a delta below 0.20.

IWM-probability-of-touching-october-expiration-cycle

Next, I want to know what the expected move or expected range is for IWM during the October 15, 2021 expiration cycle. The range is currently from 207 to just under 239.

Since we are focused on using a bear call strategy, we only care about the upside at the moment.

By knowing that the market anticipates IWM going as high as 239 by October expiration in 32 days, it allows us to choose a short call strike around that number. This will define our probability of success on the trade.

The 234 call strike with an 81.80% probability of success works. It’s not outside of the expected range, but we can adjust accordingly if needed. I want to have an opportunity to bring in roughly 20%, while keeping my probability of success above 80%.

The short 234 call strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade. Basically, as long as IWM stays below the 234 call strike at the October 15, 2021 expiration in 32 days we will make a max profit on the trade. But, as I stated before, my preference is to take off profits early and, in most cases, reestablish a position if warranted.

Also, time decay works in our favor on the trade, so as we get closer and closer to expiration our premium will erode at an accelerated rate. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration–unless of course IWM continues to spike to the upside over the next 32 days. But still, that doesn’t hide the fact that with this trade, we can be completely wrong in our directional assumption and still make a max profit.

Once I’ve chosen my short call strike, in this case the 234 call, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide spread to buy.

The spread width of our bear call defines our risk/capital on the trade.

The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread.

When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread-width and my premium increase as my chosen spread-width increases.

October 15, 2021 234/239 Bear Call Spread

Now that we have chosen our spread, we can execute the trade.

Simultaneously:

Sell to open IWM October 15, 2021 234 strike call

Buy to open IWM October 15, 2021 239 strike call for a total net credit of roughly $0.75 or $75 per bear call spread

IWM-234-239-bear-call-spread

  • Probability of Success: 81.80%
  • Total net credit: $0.75, or $75 per bear call spread
  • Total risk per spread: $4.25, or $425 per bear call spread
  • Max Potential Return: 17.6%

As long as IWM stays below our 234 strike at expiration in 32 days, I have the potential to make 17.6% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration. Again, I look to buy back a spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.75, I would look to buy it back when the price of my spread hits roughly $0.38 to $0.18.

Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration lead the way for our decisions. But, taking off risk, or at least half the risk, by locking in profits is never a bad decision and by doing so we can take advantage of other opportunities the market has to offer.

Risk Management

Since we know how much we stand to make and lose prior to order entry we can precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.

I also tend to set a stop-loss that sits 1 to 2 times my original credit. Since I’m selling the 234/239 bear call spread for $0.75, if my bear call spread reaches $1.50 to $2.25, I will exit the trade.

As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below.

 

 

 

2 comments on “Trade Idea: Learn How to Trade a Bear Call Credit Spread on IWM

    • Andy Crowder on

      David, thanks for the question. We sold the SPY 463/469 bear call spread for $0.87. Last week, we could buy it back for $0.32, thereby locking in a $0.55 return. Since we are using a 5-strike wide spread, we simply take the 0.55/4.45 = 12.4%. Hope this helps. Kindest.

      Reply

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