Energy stocks have led the way so far in 2022.
The sector is up well over 10% in 2022 alone. But the short-term push higher has pushed the sector, as seen through the SPDR Energy Select Sector (XLE), into an extreme overbought state. Typically, when we see readings this extreme a short-erm pullback or reprieve is in the cards. Of course, nothing is fool proof, right? But when I see these types of extreme readings a potential trade is soon to follow.
With XLE trading for 63.31 I want to place a short-term bear call spread going out 37 days. My intent is to take off the trade well before the February 18, 2022, expiration date. For this bearish spread example, my preference is to go with a trade that has around an 80% to 85% probability of success.
Let’s start by taking a look at the options chain for XLE with 37 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 February 18, 2022, expiration cycle that has around 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 around .20, as seen above.
Since we are focused on using a bear call spread, we only care about the upside risk at the moment.
The 68 call strike, with an 80.12% probability of success, works. It’s just inside the expected range, but we can adjust accordingly if needed. I want to have an opportunity to bring in 13.6%, while keeping my probability of success around 80%.
The short 68 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 XLE stays below the 68 call strike at the February expiration in 37 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, XLE spikes to the upside over the next 37 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 68 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 premium increase as my chosen spread width increases.
Bear Call Spread: February 18, 2022, 68/72 Bear Call Spread or Short Vertical Call Spread
Now that we have chosen our spread, we can execute the trade.
Sell to open XLE February 18, 2022, 68 strike call.
Buy to open XLE February 18, 2022, 72 strike call for a total net credit of roughly $0.48, or $48 per bear call spread.
- Probability of Success: 80.12%
- Total net credit: $0.48, or $48 per bear call spread
- Total risk per spread: $3.52, or $352 per bear call spread
- Max Potential Return: 13.6%
Again, as long as XLE stays below our 68 strike at expiration in 37 days, I have the potential to make a max profit of 13.6% on the trade. In most cases, I will make 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 $0.48, I would look to buy it back when the price of my spread hits roughly $0.25 to roughly $0.15, if not less.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to 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.
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 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 68/72 bear call spread for $0.48, if my bear call spread reaches approximately $0.96, 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. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.