Short A and buy B —each with the same weekly option expiration.
Since option A has more value than option B because option A is closer to where the stock is trading at X — when we short A and buy B, we will generate a net credit received from this trade. If you receive $1 from shorting A and you pay out $.50 buying B, then your net credit for this double trade, but single transaction is $1.00 – $0.50 = $0.50 in net credit received. With a multiplier of 100 that is common for index ETFs such as SPY, that’s $50 per contract.
You’re betting that the stock or index won’t go above a certain strike A. If it stays below that strike at expiration, then you collect the full credit. If it expires above your strike, then you begin to lose money quickly. By the time you reach strike B, you’ve reached your maximum loss.
While the probability of losing is generally low (less than 30% depending on strike selection), when you do lose, the amount of loss is often greater than the amount of gain.
How Traditional Options Traders Uses It
From a strictly mathematical point of view, this strategy generally executes for good probabilities but limited upside potential. As an example, you might have a 67% chance of making $1 or a 33% of losing $2. From a risk-neutral perspective, you just break even—maybe you’re slightly positive.
But that’s from a strictly mathematical point of view. Traditional options traders generally take this law of large numbers approach. They do hundreds and thousands of trades with the assumption that as long as they probabilities are slightly over 50%, then over time, they will make money.
How LifeStyleTrading101 Uses It
But we here at LifeStyleTrading101 don’t want to do hundreds or thousands of trades. Not only do commissions and bid-ask spreads eat up a lot of the money, but we also don’t want to sit in front of your computer screens or even mobile screens and make trades continuously like we have no other life. We work to live, not live to work. Plus we don’t want to deal with so many positions. We believe less is more.
Combine With Wave Analysis
So instead, we combine this strategy with our wave theory analysis so that we can increase the probabilities that you see in that diagram.
When the stock is trading at X, the probability at that strike is 50%. There’s a 50% chance the stock will be below it and 50% chance that it will be above it.
But based on our wave analysis, we can evaluate that it’s actually not a 50/50 probability there. When we can time it such that there is a 75% chance the stock will be lower than where it is trading it, then we can choose a few strikes above that with a higher probability than what is shown on that diagram.
Increase the Probabilities
So our goal is to identify what we believe are 80-90% probability strikes and then we short those. Then we buy strikes above that according to how much they cost and our level of confidence.
Requires less maintenance margin than the traditional call credit spread
Can still be profitable both below and above strike price A
High probability of making $X (though offset with a low probability of losing -$5x)
Costs more initial capital than traditional call credit spread
Miss out on bigger payoffs in the event stock drops a lot
In the low probability event that the stock jumps by a lot, your potential loss is roughly 5x or 6x of what your gain is
Trade Set Up
You want the stock to be below strike A when the option expires.
Max Profit = net credit received for selling call with strike A, minus the premium paid for the call with strike B.
Real-Life Examples We Traded
Here’s a real life bear call spread on SPY options that we traded for $2,600 in gains. We shorted the 210 strike and bought the 212.5 strike.
Expectation: S&P would either stay near where it’s at or go down a bit between now and expiration in 9 days. Based on our Elliott Wave Analysis, we did not expect it go down a lot between now and near-term weekly expiration — particular because it is Thanksgiving week and historically, not much usually happens during this week.
What Actually Happened: S&P moved up a little bit, but not a lot. On the day of expiration, S&P dipped towards our Strike A — and we took that opportunity to exit the trade. It wasn’t the perfect max profit of $1,500 we were aiming for, but because of a risk of a bounce, we exited the trade for $1,200 –close to our goal of $1,500.
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