The market has moved a fair amount higher since the big drop earlier this year. In the past week or so, we saw a pullback establishing new resistance. With that in mind, a call credit spread could prove to be a useful trading strategy.
Call credit spreads or, as they are sometimes called, “bear call spreads” can be an effective way to profit when an option trader expects the stock to stay below a certain area. Many times, this area is potential resistance in the form of pivot levels or maybe a moving average. Let’s take a look at how this trading strategy can be implemented.
A call credit spread is created by selling a call option and buying a higher strike call with the same expiration. Maximum profit is the credit received and it would be earned if the options expire worthless (at or below the short strike at expiration). The maximum risk on the trade is subtracting the premium received from the difference in the strikes. The breakeven point is adding the credit received to the short strike. Let’s explore a recent situation where a bear call spread might have been considered.
When Netflix Inc. (NASDAQ:NFLX) was trading around the $485 level in late July, the chart looked like this (see below).
At the time, there were some pivot levels that had acted like resistance around the $500 level. The stock had only closed once above that level since the 17th on this hourly chart. A 500/505 bear call spread with just over a week to go until expiration could have been sold for about 1.05 (5.20 (credit) – 4.15 (debit)).
The $1.05 (or $105 in real terms) represents the maximum profit that could have been earned if the stock stayed at or below the $500 level at expiration. The maximum risk was $3.95 (or $395 in real terms) if the stock closed at $505 or higher at expiration (5 – 1.05). Breakeven would be at $501.05 (500 + 1.05) at expiration.
The stock could move lower, trade sideways or rally up to $500 by expiration and still the maximum profit could have been earned. Both calls would expire worthless. That gives the trade three out of four ways to potentially profit. With everything in option trading, there are risk/reward trade-offs. The trader is risking a lot more than the profit potential, but that comes with a high probability. Each should be evaluated before any trade is ever entered.