Larry’s note: Welcome to Trading with Larry Benedict, my free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us.
My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row. And, I’m featured in the book Market Wizards, alongside investors like Paul Tudor Jones.
But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…
Price levels are a simple technical indicator that can help pick market direction.
They’re the support and resistance lines that highlight a stock’s movement. You can use these lines to get a better idea of where a stock or index is heading next.
Over the next couple of days, I want to concentrate on resistance lines and how to trade them.
To begin, let’s recap what resistance means: it’s a price level at which a stock (or index) rallies up to, but fails to break above.
In other words, it’s a level that brings in a wave of new sellers – pushing the price back lower.
When a stock (or index) runs into resistance – and that level holds – traders have a number of ways to trade it.
They can short the shares directly (or short the index via index futures). Shorting the actual shares can lead to unlimited downside and is incredibly risky. Essentially, there’s no limit to any potential losses.
Instead, I prefer to buy a put option on the underlying shares or index. A put option’s value increases when those shares or indices fall.
Trading options, like puts and calls, is the core strategy of my trading service, The Opportunistic Trader.
However, while buying a put option has its advantages – like knowing your maximum risk prior to the trade (the most you can lose is the premium you pay) – it can bring several challenges for new traders.
First and foremost, the clock is always ticking with options.
So, if the move doesn’t pan out when expected, you could lose all (or most) of the premium you paid out.
Another key challenge is volatility…
Option premiums increase when volatility increases.
For example, if you buy an option when volatility is high and that volatility decreases, you could end with a losing trade even if the share price goes in your direction.
That’s because the premiums decrease along with volatility. So that option may be worth less than you originally bought it for as volatility drops.
To help overcome these issues, I like to trade vertical spreads. In simple terms, we’re simultaneously selling and buying call options on the index as a single trade. It’s the basis of my index trading service, The S&P Trader.
Today I want to focus on one particular type of spread: the bear call spread.
Now, if you’re new to options, some of these terms might sound a bit intimidating.
Let’s break it down piece by piece.
With a bear call spread, you need to know three things:
- It’s bearish. (Bear call spread.)
- We’re trading call options. (Bear call spread.)
- And it’s a spread trade. (Bear call spread.)
Now, we’re just going to focus on the first leg of the trade today – selling a call option.
Let’s consider a resistance level I wrote about back on February 24 on the S&P 500 Index (SPX)…
S&P 500 Index (SPX)
As you can see, SPX rallied to just below 4,600 on February 2 (1 on the chart).
Here the Relative Strength Index (RSI) also met its own resistance, represented by the green line on the lower half of the chart.
Then, after trying to break above that level again (2 on the chart), SPX again ran into resistance (orange line) along with the RSI also hitting resistance.
From there, SPX rolled over and started heading down…
However, rather than buying a put option and paying premium out, the first leg of selling a bear call spread is to sell a call option. That means you’re receiving premium.
But that comes with obligations. If SPX finishes above the strike price at the option’s expiration, you run the risk of being well out of pocket.
For example, if you sold an SPX call at 4,600 and received $25 premium – and SPX rallied to 4,700 at expiry – you would be down $75 a contract. That’s the 4,600 level you sold the option at minus the 4,700 (SPX price at expiry) – or negative $100. Once you add in the $25 you received from sellig the option, it comes out to a $75 loss.
That’s why when you sell a bear call spread you must always buy another call option (with a higher strike price) with the same expiry date.
Tune in tomorrow where I’ll explain exactly how I do that…
Editor, Trading With Larry Benedict
Have you used vertical spreads in your trading toolkit?
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