Despite a smooth climb in stock prices that have continue to reach all-time highs, implied volatility has started to pick up as the calendar slides into the heart of the earnings season. Some of the financial results have been impressive, while others have been dismal, creating a binary market environment where prices surge or tumble. One way to take advantage of climbing implied volatility is to generate a position using a vertical credit spread.
Vertical Credit Spreads
There are two types of vertical spreads, credit and debit spreads. A vertical option spread strategy is one where you purchase and sell two alike options (either 2-puts or 2-calls) simultaneously, that have the same expiration date. A vertical option that is a credit spread allows the seller of the spread to receive a credit, which means the premium of the option you sell is higher than the premium of the option you purchase. A debit spread is one were you pay away a debit as the option you buy is more expensive than the option you sell.
For example, a vertical bear call credit spread would consist of:
Sell Call XYZ $50 November 17, 2017 ($1.00)
Buy Call XYZ $55 November 17, 2017 ($0.50)
Net Premium $0.50 per contract
When you sell a vertical call spread you are selling the lower call and purchasing the higher call and receiving a credit. The benefit of selling a bear call credit spread is the price of the underlying stock does not have to decline for you to experience a successful trade, it just needs to stay below the sold call strike price until the expiration date for you to receive the entire premium. This means you can have a winning trade if the price of the underlying stock moves lower, sideways or even against you.
Running an Option Samurai Scan
There are several criteria that are key to finding a robust vertical credit spread.
JD.com has been chopping around and has slid below support near the 200-day moving average ahead of its earnings which are scheduled to be released on November 13, 2017. Resistance is now former support near an upward sloping trend line which nearly coincides with the 200-day moving average $37.27. To find a bear call credit spread using Option Samurai, scan for an attractive covered call (until we will release the call spread filter in Dec). You can then protect the call with a purchase of a higher strike call, to form your bearish call spread.
The Option Samurai Scan can include any symbol, where the earnings date of the underlying stock is after the expiration of the option. This will eliminate unwanted volatility. You also want to find a stock that has a future PE ratio that is above 30, so you find a call on a stock that could be considered overvalued.
You also want to make sure that the implied volatility that is priced into the short option (which is the covered call), is in the upper half of its 52-week range. You can do this by making the implied volatility range in between 65% and 100% (in JD it’s 96.05%). You want the bid of the option to be at least $0.50, since you will have to purchase a protective call and want the net premium to be at least $0.25. When you sell a bear call credit spread you want the lower call to be an out of the money call. You can accomplish this by making the moneyness 1% to 10%. Lastly, you want the bid-offer spread to be relatively tight and less than $0.10.
(You can also add PE ratio is less than 30 and earning date is after expiration to limit the amount of relevant trades you’ll analyse)
For this trade you could
- Sell JD November 2, 2017 $37.5 Call at $0.63
- Buy JD November 2, 2017 $39.0 Call at $0.33
Your potential gain on the trade is $0.30. You broker will request margin of #contracts * 100 * ($37.5 – 39 + $0.30) or $120 per contract. Your return if both options expire worthless is 25% ($30/$120).
Your maximum loss is the different between the 2-strike prices ($1.5) minus the premium, = $1.20 or $120 per contract.
Alternative, you could also go to your dashboard and look for alternative covered call scans, using this scan as a guide.
(We plan on releasing our vertical spread scanner next month, so stayed tuned).