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In this article I wrote about the tendency for the stock market to struggle during the summer months.  In this article I wrote about one way to use options to potentially take advantage of the fact that stocks tend to struggle during the summer.  Now in this piece I will walk through an example that we can follow through to conclusion.

Two key things to note:

1. The example presented here is an “example” and not a “recommendation”

2. If you are absolutely sure that you will never trade an option during your lifetime, you are dismissed from class early today (but Thank You for checking in and please be sure to come back soon)

The Summer Credit Spread

This example uses www.OptionsAnalysis.com.  The best endorsement that I can give this site is to say that, a) I use it for all of my own, um, option analysis (what else?) and, b) in the 90’s I helped write option software that was voted “Best Option Trading System” in Technical Analysis of Stocks & Commodities magazine 6 years in a row.  But when I started using OptionsAnalysis I stopped using my own software (Yes, it breaks my heart, but better is better).

Step 1: Heavily traded options with tight bid/ask spreads 

In OA go to Website | Lists | Filter Lists

I have set up a wizard with the settings shown in Figure 1.  The idea is to find stocks with option bid/ask spreads under 2% and average trading volume of at least 1,000 options a day.Figure 1 – Filter List setup (Courtesy www.OptionsAnalysis.com)

Click “Search” to generate output results which appear in Figure 2.Figure 2 – Filter List Output (Courtesy www.OptionsAnalysis.com)

In this example 141 stocks passed the filter.  Click “Replace” to save those 141 stocks to “My Stock List”

Step 2: 2-Day RSI of 90 or higher

Go to Stocks | Rankers | RSI

I have set up a wizard with the settings that appear in Figure 3.  The purpose is to find stocks from our filtered list that are short-term overbought.Figure 3 – RSI Setup (Courtesy www.OptionsAnalysis.com)

The output results appear in Figure 4.  Note that 14 of the 141 stocks in “My Stock List” meet the RSI criteria.  Click “Replace” to save only those 14 stocks to “My Stock List”.Figure 4 – RSI Output (Courtesy www.OptionsAnalysis.com)

Step 3: Look for Bear Call Credit Spreads

Go to Searchers | Multi – Strategies | Find Trades ++

I have setup a Wizard with the settings shown in Figures 5 and 6.Figure 5 – Bear Call Credit Spread Settings (Courtesy www.OptionsAnalysis.com)Figure 6 – Bear Call Credit Spread Settings

(Courtesy www.OptionsAnalysis.com)

From our list of 14 stocks we are looking for call credit spreads for:

*Stocks trading at $10 a share or higher

*A probability of profit of 75% or higher

*14 to 45 days left until option expiration

*A delta of less than 50 for the options traded (i.e., we will only consider out-of-the-money call options, i.e., those with strike prices above the current price of the stock)

Click “Search” to generate results

The output list appears in Figure 7.

Figure 7 – Strategy Search Output (Courtesy www.OptionsAnalysis.com)

Step 4: Identify a Trade with Good Reward-to-Risk Ratio

Let’s take a closer look at the top rated trade which involves:

*Ticker LULU with the stock trading at $64.69 a share

*Selling the June 67.5 call

*Buying the 72.5 callFigure 8 – LULU Jun 67.5/72.5 call credit spread details (Courtesy www.OptionsAnalysis.com)

Key things to note from Figure 8 (which assumes trading a 7-lot):

*The maximum profit potential is +$910 (+35.14%)

*The maximum risk is -$2,590

*The breakeven price at expiration is $68.80 (current stock price is $64.69)

*There are 21 days left until expiration

Figure 9 displays the risk curves for this trade with each colored line representing the expected profit or loss based on a given price on a specific date leading up to option expiration (the profit/loss at expiration is represented by the black line).Figure 9 – LULU Jun 67.5/72.5 call credit spread risk curves (Courtesy www.OptionsAnalysis.com)

Step 5: Plan out Position Management

Now let’s look at this trade from a position management perspective.  If the stock starts to rally the last thing we want to do is sit around and wait to absorb the maximum loss of -$2,590.  So let’s set the recent high of $69.73 as our “line in the sand.”  If that price is taken out in any meaningful way we can justifiably say “we are wrong” and take our loss.

Figure 10 “zooms in” a bit from Figure 9.Figure 10 – LULU call credit spread with a stop-loss point (Courtesy www.OptionsAnalysis.com)

As you can see in Figure 10, if we place a stop-loss point just above $69.73, and we exit if that price is hit then the expected loss is somewhere between -$800 and -$900, depending on how soon that price is hit.  While this is not an appetizing prospect, the point is that by placing a stop-loss above  the recent high we turn this trade from a 1-to-2.84 reward-to-risk ratio to roughly a 1-to-1 proposition, and the stock has to rally over 8% in three weeks to trigger our stop-loss.

And remember that this trade makes money at expiration if LULU is at any price below $68.60 at expiration.

On the profit-taking side, one might consider closing the trade prior to expiration if 80% to 90% of the maximum credit can be captured.  In this case that would mean taking a profit somewhere between $830 and $920 if such a profit becomes available prior to expiration.

Summary

So is this a “good” trade.  It depends on how you define “good” I guess.  If you define “good” as “it’s a sure thing that’s guaranteed to make money”, then the answer is “No.”   If you define “good” as “selling premium on a stock that is short-term overbought and entering a position that can make money as long as the stock does anything other than rally +6.3% over the next three weeks while identifying a natural resistance point to use as a stop-loss that greatly reduces the likely dollar risk on the trade”, then the answer is “Maybe.” (It also suggests that you could use slightly less long-winded definitions of simple words like “good” – but let’s not worry about that right now…..)

Jay Kaeppel