July 21, 2004

Analysis of a Bear Call Spread
by John Brasher, CallWriter Publisher

As you know, we at CallWriter like credit spreads. A few newsletters back we promised a credit spread on the CallWriter website. We picked one on Sierra Wireless that worked out great. Since we get a lot of questions on spreads, we are devoting this newsletter issue to an analysis of the pick: why we picked it, how it worked and why it worked.

The following bear call spread trades in Sierra Wireless (SWIR) appeared on our members website in the Closer Look report on June 25, 2004. We highlighted two possible trades, one conservative (and less profitable) and one that was very profitable (but riskier). These trades if run would have expired profitably on July 16th. Let's analyze them, including why we picked them and why they worked.

A bear call spread is a credit spread, meaning that it generates a net credit (money in your pocket) when the trade is run. The bear call spread is simple, consisting only of selling a call and buying a higher-strike call. Because you pay less for the long call than you receive for the short call, it generates a credit. This spread is essentially another way to cover a call - instead of buying the stock to cover the calls, you instead buy a higher-strike call.

If the trade works as planned (meaning that the stock closes below the short call strike sold), the trader lets the spread expire, keeping the entire credit. If the stock closes between the short strike sold and the breakeven point, the trader still makes a profit, but less. If the stock closes above the breakeven, the trader takes a loss, and the maximum loss sustainable is the amount of the net spread (total spread less the credit received). It is simpler than it sounds, as this table illustrates:

In Bear Call Spread #1, the trader would have sold the JUL 35 calls and bought the same number of JUL 40 calls. The JUL 40s were bought for $0.85, but the trader received $2.30 for selling the JUL 35s. The difference - the $1.45 credit - is kept by the trader. The trader is risking a maximum possible loss of $3.55 against a maximum possible profit of $1.45, which is a 2.5:1 risk ratio. The stock went over $37 at several points before expiration, and the unlucky trader could have gotten early assignment on the short JUL35. Barring such bad luck, however, this was a winning trade.

Now lets look at the conservative SWIR trade that could have been run:

Bear Call Spread #2 was a far more aggressive trade, though paradoxically safer, the trader would have sold the JUL 40 calls and bought the same number of JUL 45 calls. The JUL 45s were bought for only $0.25, but the trader received $0.70 for selling the JUL 40s. The difference - the $0.45 credit - is kept by the trader. But note that the trader is risking a maximum possible loss of $4.55 against a maximum possible profit of $0.45, which is a 10:1 risk ratio. The stock never got close to the short JUL 40 strike through expiration and so was never in danger of early assignment.

Why did we like SWIR for a bear call spread? There were several reasons. First, it is a relatively small company, without a lot of market support depth. Second, its average stock trading volume is below two million shares daily. While this is high for an ideal bear call spread, it is on the low end for acceptable covered call stocks. Admittedly, the best credit spread trades tend to have low stock volume and other indicia of being lousy investments. In fact, if you would consider writing a covered call on a stock, it is NOT a bear call spread candidate! To paraphrase the farmer, you want a lousy stock ain't going nowhere. SWIR also had relatively low open interest in the different call series, another indicia of low liquidity and low market interest.

And best of all, it had strong resistance right at $35, the short strike sold in the JUL 35/JUL 40 spread. It subsequently tested resistance and went above $37 but couldn't hold it.

Although the 40/45 spread posed the highest ratio (10:1) of capital risked against potential return, it actually was safer, on a technical basis, since SWIR was unlikely to rise above $40 over the short run. The $35 resistance level gave significant protection against a major stock advance. That is, if the stock broke resistance and held it, there probably would have been time enough to buy back the short strike and ride the long strike for profit. The 35/40, which offered far more profit and a much better risk/reward ratio than the 40/45, was actually the far riskier trade, since the stock was already right at the $35 resistance level at the time the pick was made. Had SWIR sustained the above-$37 prices, it would have handed the 35/40 trader a loss. But as is so often the case, this was just the stock penetrating resistance briefly in a failed breakout.

Spread Trading Tidbits:

Write out of the money: Write bear call spreads that are out of the money, meaning that the short strike sold is above the stock's price at trade entry. In the above examples, the 40/45 was well out of the money by over $5 when we made the pick, but the 35/40 spread was right at the money. This leaves room for stock movement before

you have to make a decision whether to close the trade. Never, never, never write a spread that is in the money, because you are depending on a stock movement that is large enough to get the stock price below the short strike. Worse, you are depending on that movement to happen before expiration, and it won't always happen on time. (Finally, remember that there is such a thing as early assignment.)

Write above resistance: The smart bear call spread trader will have a strong resistance level below the short strike sold. The farther below the resistance level is and the stronger it is, the better. If you consistently write with resistance right at the short strike, you'd better be one heck of a chartist.

NOTE: A bear put credit spread is the mirror image: you sell a put and buy a lower-strike put that is farther out of the money. Thus is the stock price is $22, then the Short 20/Long 17.50 put spread would be out of the money.

Good luck and good trading!