On-screen text: Jeremy Kuhlman. Trading Consultant
Narrator: Hey traders, on this episode of Tradecraft I'm going to show you how I set up and managed a couple short call vertical spreads on Nvidia and Cisco using the thinkorswim® paperMoney® platform. I'm going to walk you through the nuances of my thought process. With more complex options trades like this, details like the expirations and strikes you choose, or when to stay in the trade versus when to get out, can make a big difference. Now, in this video I'll be using some fairly advanced options and technical analysis terminology, so I'm going to assume you have some knowledge and experience with options. If you're completely new to the topic or unfamiliar with the terms, you might want to check out some of our more basic options videos first. And, like all our videos, this is for educational purposes only and not individualized advice or a recommendation.
Alright, let me show you the trades I set up. After tracking Nvidia's (NVDA) rally through much of 2023, I saw some signs of potential weakness in the stock and the tech sector overall. I thought it could be a good time for some bearish trades. I decided on short call vertical spreads because they're bearish and are designed to profit from time decay. I placed one of those on Nvidia and, a few weeks later, I placed another on Cisco (CSCO) with the hope that it would stop rising too.
A short call vertical spread, also known as a bear call spread, is a bearish-to-neutral options strategy that consists of a short call and a long call with the same expiration date but with different strike prices.
The short call drives the trade because the premium you get from the sale of the contract is the source of your potential profit. You can profit if the stock stays below the short strike price, which means it can pull back or go sideways. In this scenario, time decay will erode the premium and make the short call cheaper. If that happens, when you buy it back to close the trade, the difference is your profit.
Animation: An illustrated stock chart is labeled with a short call at one price and then a long call at a higher price.
Narrator: The long call defines your risk in case the underlying's price moves against you and shoots higher. Unfortunately, the cost of buying the call reduces your potential profit. Of course, many traders feel the cost is worth it to protect against much larger losses.
Another important risk to understand is if the stock price closes between the two strike prices at expiration. If that happens, you'll likely be assigned on the short strike, requiring you to deliver 100 shares of stock at the strike price. Your long call won't help because it will have expired worthless, resulting in a possibly unanticipated short stock position, which is subject to unlimited risk if the stock rallies.
Now that I've explained how the spread works, I'll look at that Nvidia trade. While Nvidia didn't have a long-term resistance level to draw from, I was bearish on it because it's the fourth largest component in the Nasdaq-100® (NDX), which was nearing a potential resistance level set back at the end of 2020 around 1,600.
The stock had also recently pulled back from its high, creating some large red candles, which suggested that traders may have been taking profits. And the recent bounce appeared to be struggling because the last two rallies had been countered by sellers. Look at how the candles rose higher during the day but closed below their opening prices. Of course, none of these technical signals guaranteed the stock would pull back.
Before I sold the spread, I considered some potential exits. First, Nvidia was scheduled to report earnings on August 23. I didn't want to be in the trade during earnings. In fact, because implied volatility often ramps up in the week ahead of earnings, it may be harder for short spreads to be profitable. So, I planned to close a week prior to earnings.
Also, I used the Risk Profile in the Analyze tab to help me determine if I should stay in the trade or close it.
Finally, if I gained 80% or more of the max gain, I planned to close the trade to take the profit and remove the risk from my account.
The first step to open the trade was selecting an expiration. When selling options, the shorter the expiration, the faster the time decay. But if I went with too short a time frame, I wouldn't get much premium. Additionally, I want to be out before implied volatility ramps up ahead of earnings on August 23. Since my plan was to be out about a week before the announcement, I went with the 18 AUG 23 expiration.
Animation: The mouse clicks on the Strikes box and 20 is entered. The mouse then clicks on the Layout list. A window opens and new columns are added.
Narrator: To pick my strikes, I needed more to choose from, so I increased the number available on the option chain. Next, I changed the layout to include the probability of expiring out of the money, delta, and open interest.
When selling options, many traders use delta as a rough estimate of an option's probability of expiring out of the money. So, they'll look for strikes with a delta around .30 because they tend to offer a good balance between the size of the premium and the probability of expiring out of the money.
I chose to sell these spreads out of the money with the hope that the stock's price stays below the short strike price until expiration. This allows time decay to eat up the premium.
Animation: The risk profile for a short call vertical shows that max gain is at lower prices and the max loss is at higher prices.
Narrator: So, the strategy has a bearish to neutral bias and, depending on how far out of the money the contract is sold, the stock can even rise a little. If it climbs too far, or the options premium increases, it'd likely led to a loss.
Another benefit of out-of-the money strikes is that they tend to have lower vega than at-the-money options, so implied volatility spikes should have less of an impact. Rising implied volatility causes option values to rise, which is bad for short option strategies because they make the premiums more expensive. However, if the stock price stays below the strike price, the increased value from implied volatility will typically melt away over time.
Getting into the trade, something on the options chain caught my eye: The 500-strike had over 12,000 contracts, a lot more open interest than to the strikes above and below it. This told me that the market may also be thinking that the stock won't close above $500 by expiration. Additionally, the probability of expiring column shows the 500-strike is at a 72% likelihood of expiring out of the money. One reason for the high probability is because the strike is more than $40 higher than the current price of $459. Considering all that, the 500-strike looked like a good candidate for the short contract.
For the long call, I went with the 510 because it's inexpensive and also has high open interest, with more than 6,300. I went ahead and made the trade.
The order ticket showed that I was selling the 500-510 spread for a net credit of $2.20, or $220. If the stock was to skyrocket above 510, I could have lost $780, not accounting for commissions and fees. That meant I was risking more than I could potentially make, so it was important that there was a high probability that the stock would stay below the strike price I chose.
I sent the trade. Then I looked at the filled orders and saw I actually got a little better fill at $2.25 because I was credited $9.10 for the short option and paid $6.85 for the long option. This also meant the max gain was $225 and the max loss is $775.
I came back after a few days to see how the Nvidia trade was doing. The chart showed the stock had tumbled quite a bit. I placed the trade on July 27, and the stock had fallen about $50, which was a really good sign.
Implied volatility had risen, which may have cut into the profitability of the trade.
Looking at the P/L Open, the trade was up $223 overall, which means it gained more than 99% of the max gain. This is because the short call was up $898.50, while the long call was down $675.50. This is basically how I expected the strategy to work. It may be tempting to lament the fact that the long option was cutting into the profits, but that's the cost of managing risk. If I didn't have the long call, and the stock had unexpectedly risen, my potential losses would be unlimited.
I was seven days from expiration so I did have time to try to squeeze a little more out of it. But I was more concerned with risking that profit by staying in the trade.
On the Monitor tab, I could see that the mark price for the short call was ten and half cents and the long call was eight and half cents, which meant I could close the trade for $0.02 plus fees. So, there was really no reason for me to hang on to this trade any longer. I closed it out to take off the risk and keep that $223.
Okay, that trade was about as textbook as one could hope because the stock fell, and time decay worked for me.
Now, let's talk about my second trade on Cisco (CSCO).
Cisco was uptrending but had recently gapped higher on an earnings announcement. The stock rallied higher throughout the day, but eventually pulled back creating the long wick on the candlestick and closing at $54.73. The influx of sellers could be seen as profit taking, which could be seen as a bearish sign for Cisco in the near term.
Implied volatility was also falling, which should help pull some of the extrinsic value out of the options.
First, I selected an expiration. I went with the September 15 2023 to balance premium and the speed of time decay.
Animation: The 55 call contract shows open interest of 39,937. The 57.50 call has open interest of 28,725.
Narrator: Next, I selected the short option by looking first at the open interest. The 55-call had the most, with nearly 40,000 contracts. The 57.50 had a lot of open interest too, but there was a big drop off between the two strikes.
Animation: The mouse clicks on Layout and the Implied Volatlity, Probaility of OTM, and Delta layout is selected.
Narrator: The probability of expiring out the money also showed a substantial difference between the two strikes. A different layout showed that the 55-strike had a 48.59% probability of expiring out of the money, which wasn't great. The delta at .54 was also high for a selling strategy.
Animation: The 55 strike had a bid price of $1.32 and the 57.50 strike had a bid price of $0.27.
Narrator: The 57.50-strike had an 81.46% probability of expiring out of the money and a delta of .20 but premiums were small.
I decided to go with the 55-strike for my short call, hoping the stock would pull back. In doing so, I also assumed a higher risk of early assignment because the strike price is closer to the stock price. l used the 57.50-strike for the long leg of the spread. The order ticket showed a potential credit of $1.06. Before sending it, I analyzed the trade in the Risk Profile.
After setting the price slice to breakeven, I saw that I had some room if the stock rises a little. The graph gave me a 62% chance of this trade having some profitability not accounting for fees. I just needed the stock price to stay below $56.
Based on that analysis, I entered my trade for the 55-57.50 short call vertical for a credit of $106. Unlike Nvidia, Cisco doesn't have an earnings announcement to exit ahead of. So, my first exit would be if the stock moved above the break-even point of $56 so I could limit any losses and mitigate the risk of early assignment. Of course, early assignment isn't a risk in the paperMoney platform, but it's real risk in a real trade. The second exit was if I get 80% or more of the premium.
OK, three days after I placed the trade, I checked on how things were going. Cisco had moved higher, closing at $55.46. However, the price is still below the high set four days ago. I hoped the bears would hold that line and maybe even push back a little.
Implied volatility fell a little more but had leveled out the last couple of days.
The trade wasn't too bad off, with the P/L Open showing a loss of $3. The short call was near $1.38 while the long call was around $0.29. This meant if I were to close the trade, it would've cost me $109.
Animation: The mouse right clicks on the trade revealing a list. The mouse hovers over Create closing order, which provides the choices and cost of the closing the entire spread, the long call, and the short call.
Narrator: When I opened the trade, I received a credit for $106. So, I would've had to pay the $3 difference to close at a loss.
However, it was still early because there were 24 days to expiration. The stock was still below the break-even point of $56. So, I stuck with it and decided to check back later.
One day after I last checked in, the stock kept moving against me. It broke above the recent intraday highs.
Animation: A candlestick chart of the S&P 500 shows the price rose from 4382 to 4428. However, the last four candles have stayed in a small range.
Narrator: However, the S&P 500® appeared to be turning over, which led me to believe the stock might do the same.
The Monitor tab showed a loss of $17.50 on the trade, due to a $19 loss on the short contract but a $1.50 gain on the long one. This wasn't too bad when you consider the max loss is $144, but I certainly didn't want to experience that either.
The question was, should I stay, or should I go? The risk profile helped me make that decision.
The price was at $55.82, which was still below the break-even point of $56. If the stock moved past $56, I'd close the trade. However, if the stock stayed put, time decay could still result in a small profit. Plus, I was still hoping for the stock to turn down.
I stuck with it, but I kept an eye on it.
About a week later, I checked to see how the trade stood. According to the Monitor tab, the trade was down $58.50. I had a loss of $64.50 on the short contract, but a gain of $6 on the long contract. Let's see what happened.
The price of the S&P 500 rolled over like I thought it would the week before, but it bounced back and appeared to be heading higher and Cisco appeared to be rising with it. This was a bad sign.
I looked at the short call vertical risk profile to decide if I should exit the trade. The stock price had moved past the $56 break-even point, which was my line in the sand. So, I decided to close this trade before things got worse.
The order ticket showed that I had to pay $1.59 to close. I sold the short vertical for $1.09, which meant I stood to lose $0.50 on the spread, or $50 on the trade. I closed the trade and took the hit.
So, here are a couple of takeaways from these trades.
Using open interest to determine strikes can be helpful like it was for the Nvidia trade, but just looking at open interest isn't enough, as you saw in the Cisco trade. Despite what the chart was doing, a benefit of short call vertical spreads is that when they're sold out of the money, they can be somewhat forgiving. A combination of using technical analysis, expiration probabilities, and open interest can increase your likelihood of success.
Some potential criteria could be selecting short strikes with a delta of .30 or lower and looking for contracts with at least a 70% probability of expiring out of the money. Of course, having these rules or guidelines are only effective if you use them like I did for Nvidia but didn't do for Cisco. So, don't be tempted by those fat premiums and break your rules.
Next, the risk profile tool can help you determine whether to stick with a trade or close it because of the factors it considers other than the stock price. It's tempting to look at the Cisco trade as a complete failure, but that's not necessarily the case. Selling a contract that was further out of the money would've increased the likelihood of success and lowered the premium, but the risk profile tool helped me gain insight to better manage the trade and helped me to limit my losses.
There were a couple of times I looked at the Cisco chart and saw the stock rising, but the risk profile showed that the trade was still below the break-even point because time decay and declining implied volatility were offsetting rises in the underlying stock. Seeing these factors play out allowed me to give Cisco time to turn.
Unfortunately, it didn't turn, and I had to take a loss, but a relatively small loss.
Trading options has its inherent risks, but short call vertical spreads are one way for traders to potentially profit on a stock they think is bearish and allow time decay to work for them.
Keep in mind that options trading involves unique risks and is not suitable for everyone and certain requirements must be met to trade options at Schwab. Check out our other videos to learn more.
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