WOW14 – Trading credit spreads (cash inflow I) Host: Georgio Stoev, Product Manager November 17, 2018

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Week 14 The Bear Call Spread Review of the markets/watchlist Introduction to Vertical Credit Spreads The Bear Call Spread How to set it up and manage Review

Review of Markets S&P 500 tracking stock (SPY) down 8.5% vs. VIX 30% Euro-Stoxx 50 (FEZ) is down 6.3% China (FXI) down 10.5% Bonds 3.4% Oil down 22% Volatility in the market is creeping back up to Aug/Sep levels 2016 could be a repeat of 2015 in volatile trading What is investor to do? – most obvious one to adhere strictly to money management rules (proper position size, adjustment of trades, using ETFs rather than individual stocks to name a few)

What are Vertical Credit Spreads? The term “spread” is a loosely used term that can describe any multi-leg option strategy (covered call, bull call and so on) Literary it means the difference between the bid and the ask price Vertical spreads involve buying one option and selling another on the same stock, with the same expiration month, calls or puts Credit spread is created when a higher- priced option sold against a purchase of a lower-priced (0.10 Bid – 0.40 Ask) Net= 0.30 (debit) or (0.40 Bid – 0.10 Ask) Net =-0.30 (credit)

What is a Bear Call Vertical Spread Investor buys one call and sells another Same underlying security Same expiration Different strike prices Credit spread is created when a higher-priced option sold against a purchase of a lower-priced

Bear Call Spread Example Wells Fargo stock is at $48.21 Short term forecast: bearish to neutral Sell 1 WFC Feb 50 Call at $0.57 Buy 1 WFC Feb 52 Call at $0.19 Net Credit $0.38 The short 50 Call main purpose is to generate income The long 52 Call simply limits the upside risk Strategy does best when price declines or stays steady Time element is helping the strategy (time strategy) Maximum gain is net credit received of $0.38 Maximum loss limited to the width of the spread reduced by the credit received

Bear Call Spread Example (cont’d) Sell 1 WFC Feb 50 Call at $0.57 Buy 1 WFC Feb 52 Call at $0.19 Net Credit $0.38 Breakeven = $50.38 (lower strike price + credit received) Maximum Profit = $0.38 Maximum Loss = $1.62 (width of spread – net credit received) ROR = 0.38/1.62 = 23% + BEP $50.38 (expiration) 40 45 50 55 60 65 -

Possible outcomes at expiration Scenario 1 – stock moves further down to $45=> you would collect on whole premium Scenario 2 – stock at $48.21=> you’d collect the whole premium Scenario 3 – stock moves up marginally to $50=> you could collect partially or breakeven at $50.38 Scenario 4 – stock closes above BEP of $50.38 => your loss is limited to $1.62

Setting up a bear call Find a stock or ETF (SPU, IWM, XLE or other liquid) >5M daily volume Technical Analysis Identify a downtrend (trade with the trend!) Stock near or at resistance Choosing expiration and strike prices Allow for 20-40 days Sell at a minimum 5% OTM option, buy the next one up Technical indicators like Average True Range (ATR) could help you get a sense of the stock price More bearish investor can choose to sell ATM strike, as a variation Try to collect at least $0.30 on the dollar (before commissions), more if more aggressive

Managing the trade (takeaways) Start small in the papermoney environment Use money management rules, don’t risk >1% of account value Check the trend of the market (S&P 500) and the VIX If volatility (VIX) is relatively high, options tend to have more premium Try to avoid trading around earnings Don’t overact to daily price fluctuations, remember these are time spreads “Let the paint dry before you put another coat of paint” Close the trade when at least 80% of the credit received is bled out of the spread Close the 4-10 days before expiration Monitor daily but adjust once, typically near expiration

Bear call spread (review) Bear call spread is a bearish to neutral strategy Higher volatility in the market could help It is a risk-defined income strategy Margin equal to the width of spread minus the long options is required Make sure you have free cash available in the case you need to close the position To close the position you would enter into an offsetting order (buy to close/sell to open)

Questions? GEOS@saxobank.com References: http://www.optionseducation.org/strategies_advanced_concepts/strategies/bear_call_spr ead.html https://www.tradingfloor.com/topics/optionslab https://www.tradingfloor.com/traders/georgio-stoev