One strategy for growing your portfolio is using Bear Call Spreads to get paid to trade. We can look at a relatively low risk trade using a Bear Call Spread on the Russell 2000 Index. The Russell 2000 Index (^RUT) is a small-cap stock market index of 2000 small companies. In downtimes smaller companies will be harder hit and we can assume that the Russell 2000 Index will have a hard time climbing upward. If we look at a chart of the Russell 2000 Index we see that has encountered resistance or in simple terms it has had a hard time going above 625.
We can make some money by selling the January 10 650 CALL. This is an options contract that we sell to someone else. These options contracts are going for $2.66/share. So we could make $266 per contract sold. We would get to keep this amount as long as the ^RUT stays below 650. If it goes above 650 our losses could seriously add up. To protect against this possibility we also purchase the January 660 CALL contract from someone for $1.26. This brings our initial net profit down to $1.40/share or $140 per call spread. This limits the maximum amount you could lose on making this trade. The advantage is that the January 660 CALL is gaining in value along with the January 650 Call if ^RUT goes up. To get out of this trade if it does go bad you would do the opposite of how you entered. That is you would sell the January 660 CALL you bought and take part of the proceeds to buy the January 650 CALL you sold.
Max Profit occurs when ^RUT below the price of the CALL you sold. I this case as long as ^RUT is below 650 you get to keep 100% of the 1.40/share from making this trade.
Break Even occurs when the price of ^RUT is equal to the price of the call you sold (650) + the premium you received (1.40). In this case you would break even if ^RUT made it to 651.40 and only lose money after it went higher.
Max loss would occur if ^RUT were higher than the CALL you bought (660).
If we were to go and buy 3 contracts (300 shares) using this setup we would see this calculation in our trading software.
Max Profit: $420.00
Max Loss: $2580.00
You collect the $420 immediately if you click send. You only start to lose money if ^RUT makes it above 651.40.
Is this trade worth the risk? We can calculate that to make our own decision before hitting send.
On Dec 21 we used the Analyze Risk tab in Think Desktop to see what the odds were of ^RUT being under 651.40 by the date the options contracts expire in January. Based on this chart the odds were 100% likely that ^RUT not go above our break even point.
We didn’t get filled so we tried again on Dec 22 and raised our price. ^RUT went up 5 points in one day which was a big move and we performed another risk analysis. Now there is 72% chance of ^RUT being under 651.40 by January 15. The odds are greater than 50/50 and much better than winning the lottery. We also set an email alert when ^RUT gets to 645. This gives us an opportunity to bail out of this trade before expiration.
Bear Call Spreads are useful for speculating on a security not rising above a given price. In this case we didn’t have to have any money up front to invest and made a profit of $420. With a more than 70% chance of success this was worth the risk since ^RUT is going to have a hard time breaking above 625. We’ve set email alerts in case things continue to slide in the wrong direction over the next 23 days. Never trade and forget because you could end up with an unpleasant surprise.