Use This Strategy To Generate Income From Falling Stocks With Limited Risk

Monday, September 30, 2019 - 2:30pm

by Profitable Trad...

Option contracts can be versatile tools, allowing investors to make speculative bets while putting a minimal amount of capital at risk. They can also offer traders opportunities to generate reliable income.

Today, let's talk about an income strategy that works well for stocks or ETFs that are expected to remain stable or decline in value in the near term.

As a quick refresher, the owner of a call option has the right but not the responsibility to buy 100 shares of the underlying stock at a particular price point, known as the strike price.

The buyer of a call option pays for this right when buying the contract. The purchase price, typically referred to as the option premium, depends on a number of factors including the price and volatility of the underlying stock, and the amount of time left before the option expires.

Call options trade on an exchange just like stocks, so you can purchase or sell these rights much the same way you would buy or sell shares of individual stocks.

It is important to note that as a trader, you can sell these call options, giving someone else the right to buy stock from you, whether or not you actually own the stock in your account. And you can buy back these contracts (at the market price for the specific contract) to close out your obligation.

Setting Up a Bear Call Spread
Spread trades typically involve two or more option contracts that work together to create a particular potential return profile, along with specific risk qualities. Option spreads can be used to benefit from multiple scenarios including bearish, bullish and flat price action.

A bear call spread is typically used when a trader believes a stock will drift lower or, at minimum, remain stable. This type of spread is set up by purchasing a call option and then selling the same number of call options on the same underlying security with the same expiration date but a lower strike price.

Let's use an example of a stock that is currently trading near $48. We may choose to sell the three-month $45 calls and purchase the three-month $50 calls.

The $45 calls are considered in the money, meaning they already have intrinsic value. This is because the owner could exercise his right to purchase the stock at $45, and this would be below the current market price for the stock.

On the other hand, the $50 calls are considered out of the money, meaning the stock has not yet crossed above the strike price. While an investor may pay a particular price for these options based on the expectation that the stock may trade above the strike price, there is no benefit in actually exercising the call option because you could purchase stock cheaper in the open market.

The $45 calls will therefore be worth more than the $50 calls. So when we sell the $45 calls and buy the $50 calls, we actually receive a credit for putting on the trade. Depending on the volatility of the stock, we could expect to receive $4.50 for selling the calls and pay $1 for buying the calls. This would result in a net credit of $3.50 for the trade.

Three Possible Outcomes
There are essentially three possible scenarios for how a bear call spread can work out. First, the stock could fall below the lower strike price. This represents our maximum profit opportunity. 

Second, the stock could close between the two strike prices. This would leave us with a short position in the stock, which may or may not be profitable depending on the price point. 

Third, the stock may end up above our highest strike price, which would result in our maximum (capped) possible loss.

In the first scenario, we gain our maximum profit because neither call option will be exercised. This means that we get to keep the $3.50 that we received when entering the trade.

In the second scenario, we will be obligated to short shares of the stock at the lower strike price. This is because the owner of the $45 call option has an incentive to buy shares from us at $45 rather than paying a higher market price for the stock. So we will essentially take on a short position with a cost basis of $45, but we still get to keep the $3.50 we received from setting up the trade. So our breakeven point is $48.50.

In the final scenario, if the stock trades above $50, we will still be required to short the stock at $45, but we will also have the right to buy shares at $50. This means that we will take a $5 loss as we are purchasing the stock $5 higher than we are selling it. However, since we received $3.50 per share when setting up the trade, our net loss will only be $1.50.

As you can see, a bear call spread is a great way to benefit from a stable or falling stock price, while limiting risk. Profits are typically accumulated when the stock is stable, and they are highest when the stock trades below the lower strike price. At the same time, our risk is capped to the maximum loss if the stock trades higher.

(This article originally appeared on ProfitableTrading.com)

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does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.