Since October of 2007, markets have declined almost 45% with the likelihood of even more weakness in 2009. In previous articles I have written about shorting double beta ETF’s like the DDM or QLD, or trading inverse ETF’s like the DXD and the QID, both of which will go up in value as markets tumble. These two strategies have been remarkably profitable during the last 18 months.
But as the bearish longer term trend takes an expected breather now and then, and as markets can move sideways sometimes for months, I regularly get this kind of question, “Is there anything I can profitably trade during these choppy periods?” Actually, there are many approaches to profits at such times, but one I like to trade, which doesn’t require a lot of baby sitting, is that of selling options. I use a strategy called a “bear call credit spread”.
It sounds like a mouthful, but basically it is a easy strategy where you sell an option to collect premium, and then use some of that premium to buy second option as a hedge. In this case, our goal is to earn an income instead of price appreciation. Here’s how it works:
When markets have high volatility but lack a real trend, option prices tend to explode and then implode on a shorter term basis. That sets up a good chance to simultaneously sell an option closer to the “at the money” strike price, and purchase a second, less high-priced option at a strike price slightly further out of the money. In this strategy, you hope both options will lose time value and ultimately expire worthless. If they do, you keep the difference between the two option premiums.
For example, when the intermediate cycle, which is one of the ideal market trends to follow, topped out at the beginning January, the first consideration might have been to buy an inverse ETF, secondly to buy puts on the indices, and thirdly, you could have sold a “bear call spread”. Using the latter strategy, here’s how it would have played out:
At the time, the QQQQ was trading around $30-$31. The QAVBF (Feb 32 Call) was selling for $1.15. The QAVBH (Feb 34 Call), was selling for around $.40. The net difference between the two was $.75. By selling the QAVBF and buying the QAVBH, you would have had $75 added to your account for each contract pair purchased and sold. Ten contracts would have added $750 to your account (minus commissions).
Your blow-up risk, had the market moved strongly against you to the upside, and you had for some reason, failed to close the short call position (QAVBF), would have been $2 per share. That represents the difference between the two strike prices ($34 minus $32) minus the net premium you collected. In other words $2-$.75 or a risk of $1.25 per contract.
Today as I write this article - February 3rd, the QAVBF is selling for $.18 and the QAVBH is at $.03. In other words, both are nearly worthless, and even though you could wait for them both to expire worthless, I like to “unwind” the short leg of the position, and purchase back the QAVBF contracts so that only your long call remained. Doing so would let you keep the remaining $57 per contract (sold for .75, bought back for .57, minus commissions), with the possibility that if the markets again turn up before expiration, your long QAVBH contracts could go up in value too.
When you get familiar with the strategy, it can become a great tool to generate monthly income in almost any market. I like to describe it as “selling stuff that’s apt to become worthless, to anxious buyers who are willing to pay you good money for it right now.” Almost sounds a little like on the internet auctions too, doesn’t it? Except in this case, you’re always guaranteed a buyer!
About the Author
Stephen Swanson is the author and publisher of: http://www.TheMarketForecast.com.
Steve’s daily stock market predictions accurately show which direction stock markets will move, and how to reap big profits in both bull and bear market trends.
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