What a back-and-forth market it has been at these levels… things may be getting a bit shaky, and I believe it’s important to be prepared for a pullback.
Am I calling for a massive reversal at these levels?
All I’m saying is that if things take a turn, it’s important to have strategies in place that can benefit if stocks drop.
However, when people think about “betting against stocks” the first thought that typically comes to their mind is shorting shares.
The thing is… that can be pretty dangerous, and the risk is undefined.
There’s actually a way to establish a bearish opinion… with defined risk.
A Risk Defined Strategy To Bet Against Stocks
When the market feels shaky or there’s a resistance level I think a stock can’t break above… I look to place bearish bets.
More specifically, I want to use a bear call spread.
To me, I think there can be a higher probability of success than shorting the stock outright, or buying puts, when I use a bear call spread
So how does this strategy work?
Well, here are 3 steps to finding a potential trade:
- Find a stock or ETF that I expect will stay below a certain level within a set timeframe.
- Center my options series around that time frame, sell a call option that aligns with my expected top. So, if I expect the shares to stay below $100 through within a specific timeframe, say 3 weeks, I might sell a $100 strike price call option expiring 3 to 4 weeks until the expiration date.
- To protect my trade in the event the shares rocket beyond the short call option, I would buy a call option at a higher strike, in the same series, maybe the $105 or $110 strike price calls.
So if the stock falls and stays below the level I select, then in theory, I would be in a position to profit. That means the stock can stay sideways, rise a little, or even drop a little… just as long as it stays below the strike price of the short call options, I’m in the clear.
Now, here’s a look at the bear call spread at expiration.
If you look at the profit and loss (PnL) diagram above, the bear call spread has defined risk and defined reward.
So I believe it helps to actually size my positions… and know where my break-event point is.
Now looking at the diagram above…
To set up the bear call spread, you would want the stock price to be trading below strike price A. That said, this means you’re neutral to bearish. In other words, you think the stock will trade below a specific level.
For example, let’s say you notice a bearish chart pattern in a stock that’s currently trading at $98. Now, you think the stock will stay below $100.
That said, the bear call spread could be set up by selling $100 strike price calls, while simultaneously buying calls with a strike price of $105. Now, let’s assume you were able to place that trade and receive a net credit of $1.50.
That said, your breakeven is equal to strike price A ($100 in this example) plus the net credit received ($1.50 here). That means if the stock starts to trade above $101.50… you would start to lose money.
If you plan to bet against stocks, think before you short shares outright. Now, if you want to learn more about credit spreads and how I use them to my advantage…check out my eBook, Wall Street Bookie. Click here to claim your complimentary copy.