A short call credit spread (known also as a bear-call spread or short call vertical) involves selling an out of the money call option for an account credit, while simultaneously buying a less expensive further out of the money call option for an account debit. The difference between the money you keep from the sold option and the money you shell out to buy the other option, always a net account credit, represents your maximum potential profit on the trade. Vertical spread trading has a short but easy learning curve, and Investopedia does a great job explaining Bear Call spreads and how to trade them. Today, we'll focus on applying Chaikin Analytics and run through a checklist to see if a Bear Call Spread on American Airlines makes sense. We'll assume a basic understanding of option spread trading for this exercise.
American Airlines - Bear Call Spread Checklist
- WATCHLIST: Liquidity when trading option spreads is of paramount importance. My broker, TD Ameritrade, maintains a watchlist of stocks that trade millions of shares and option contracts each day, resulting in bid-ask spreads on options that are only a few pennies wide. The list is titled Pennywide Options, and I import it directly into Chaikin Analytics, so it's easy to quickly find bearish stocks and trading signals quickly. The stock we are considering today, American Airlines, trades millions of shares a day and has thousands of contracts open at various strike prices for the July expiration.
- BEARISH TADE CRITERIA: Chaikin Analytics gives us confidence that the stock is likely to move down in price or go nowhere at all. Weak industry group, Bearish Power Gauge, negative relative strength meter indicating that market agrees with Power Gauge, persistent negative money flows suggesting that large institutions are selling shares, overbought oscillator, and downward sloping short and long term Chaikin trend lines.
- ENTRY SIGNAL We look for Bearish or Very Bearish rated stocks with sell signals on our watchlist of optionable stocks. Today, there is an Overbought Sell signal on American Airlines. This is a shorter term signal that takes about 10 days to play out according to Marc Chaikin.
- EXPIRATION MONTH: We prefer selling options with 4-6 weeks left to expiration, but will make exceptions. The more time we allow for our directional bias to play out, the more useful Chaikin Analytic's fundamental factors are to us....because price always catches up with fundamentals. The closer we get to expiration, the more important technical and timing signals are to the trade. American Airlines has an earnings announcement on July 23d, so we'll choose the July 17th expiration, less time than we would like, but we have conviction about never holding any call spread through earnings, unless trading the announcement itself.
- STRIKE SELECTION. As I write this, American Airlines is currently trading at $41.56, with short term resistance at $42 and $45.50. With a Bear Call Spread, I look at an option's delta, which is listed next to each strike price, as a proxy for probability. As an option seller, we want any option we sell to expire worthless...OUT of the money. So I look for strike price that has an option delta of between .30 and .40, which translates into roughly a 30-40% chance of the trade expiring in the money and going against us. For the July 17th expiration, the $43 call strike has a .37 option delta. That gives us about $1.50 to the upside berfore the trade becomes a loser. That's the great things about vertical spreads, one's thesis can be incorrect, yet one still can make maximum gain.
- A $2 wide vertical currently delivers a $.50 total credit. (SELL -1 VERTICAL AAL 100 JUL 15 43/45 CALL @.50 LMT) and $1.50 in total risk. Return on risk is 33%. We will wait until after the market opens tomorrow, and if American Airlines opens up, we'll likely get a higher credit.
- WHAT ABOUT IMPLIED VOLATILITY?: This trade will be hurt by an increase in IV. Option selling strategies are best in high implied volatility environments, especially when this volatility (or fear) subsides during the life of the trade. The market puts a premium on option prices when traders are most fearful. And since the fear of what bad thing COULD happen is almost always worse than whatever ACTUALLY happens, a trader who steps in and sells while the majority stares hopelessly into the abyss is generally the one laughing all the way to the bank. Since, the purpose of our Bear Call Spread selling strategy is to partially offset the directional risk in a portfolio of long stock and since our trades will benefit from the downward movement in price that often accompanies an increase in IV, we'll not worry about negative Vega (volatility) for this strategy. So, we'll be considering candidates for call credit spreads whether the VIX is trading at 12 or 42.
- We can, however, use IV rank to pick one underlying over the other if all other things are equal. We'd give preference to underlyings trading in the upper half of their historical Implied Volatility range when choosing from multiple candidates.