Bear Call Spreads in Financials

Using the ONN Idea Generation Platform (IGP) today to search for bear call spreads in the financials, four trade ideas popped up in the top ten with October expirations. The IGP selects for high-return opportunities regardless of expiration or volatility.

But essentially, if it finds an out-of-the-money (OTM) credit spread, it will be trying to capture the implied volatility (IV) time value of that spread relative to the width of that spread (distance between the short and long strikes). And it measures potential return (max return being the spread credit) against the capital you would have to post to sell the spread, i.e., the difference between spread width and premium collected.

Here are the four spreads, with implied volatility (IV) vs historical volatility (HV) data from www.OptionsHouse.com:

1. Intercontinental Exchange (ICE) Sell Oct 95/100 call spread for $1.05, 30-day IV at 55% vs. HV below 40%
2. Deutsche Bank (DB) Sell Oct 75/80 call spread for $1.05, 30-day IV at 50% vs. HV at 40%
3. Goldman Sachs Group Inc. (GS) Sell Oct 190/195 call spread for $0.98, 30-day IV at 40% vs. HV below 25%
4. Credit Suisse Group (CS) Sell Oct 55/60 call spread for $0.95, 30-day IV above 40% vs. HV around 35%

These are all $5-wide spreads, so $5 minus the credit received is the maximum amount of capital you are risking to do this trade. I like looking at credit spreads with as little time to expiration as possible to take advantage of time value decay in out-of-the-money options and to have this risk exposure for the shortest time possible.

The potential "return on risk" (premium collected/minimum capital required to cover max loss) for each of these spreads is around 25%. For instance, if the credit received is $1.00 on a $5-wide spread, then the capital required as margin collateral is $4.00 because that’s the most you can lose. And your potential return is $1.00/$4.00, or 25%.

For one of today’s ONN Trading Ideas, I picked Goldman Sachs (GS) because I felt the probabilities were favorable with GS unlikely to take out its 52-week high at $188 before October expiration in 14 days. The other candidates may suit investors who follow those stocks more closely and are comfortable with their volatility.

Intercontinental Exchange (ICE) is the highest volatility stock among the four and its option prices reflect that. Since falling from $110 to $85 in only two days in early July on the back of news that the CFTC was exploring futures trading position limits, plus an analyst downgrade, ICE shares are struggling to get over $100 again and the chances are good it won’t in the next two weeks. But option traders have to evaluate the risk and volatility themselves before acting on any trade idea.

Selling an out-of-the-money bull put spread simultaneously with any of these bear call spreads would generate more premium income and reduce the overall risk of just selling one or the other. This trade would create the iron condor that we love to trade here at ONN. See my articles and trade ideas on the XLE and IBB from Sep 4 and Sep 14 for examples.

"Mind the Risk, Bank the Profits!"