How To Win 5 Different Ways On AMAT Vertical Spread

Going into next week, you will hear a lot of talk about the 50-period simple moving average coming into play as support on SPY.

We joined the talk in an article yesterday as we explained how big of a support level this was. It has held as support 10 times already this year. Price has bounced back up to new all-time highs after each test of support.

We did end up seeing SPY close below this level Friday afternoon. It wasn’t a huge break, but SPY did close the week at $441.40 which is $.30 below the 50 SMA. This opens the door for much bigger selling going into next week. We could potentially see a move down to the 89 EMA which is at $433.73.

With this in mind, we have been looking for more bearish positions over the last week. However, we also need to remember that this support level has held 10 times this year. If we see it hold again, we don’t want to be in ultra-aggressive bearish positions.

The nice part about trading options is we can use different strategies that best match our risk tolerance and market outlook.

One of those strategies is a credit spread. This trade is put on by selling a vertical spread to open the trade. Since we want to lean bearish, we will be looking to sell an out of the money call spread.

Vertical Spread

A vertical spread is put on by simply selling an out of the money option with the strike price closer to the stock price and then going farther out of the money to buy an option which will leave us with a full risk defined trade.

This trade will give us 5 ways of making money on the trade. Since we are selling a call spread, we will make money if the stock moves up, down, or sideways, as long as price stays below the strike price of the option that we sold. We also make money from time decay adding up and from volatility decreasing.

Applied Materials (Symbol: AMAT) Trade Example

For our trade example, we are going to use a trade that we sent out as part of our Nasdaq Options Superstars program last week. This is a signal service where we send out trade alerts to our customers anytime we are opening or closing a position.

Applied Materials (Symbol: AMAT) is one of the few stocks that made it through the market wide selling last week without much damage done on the downside. We like to use the 130-minute chart for our analysis. The stock is still overbought on the 130-minute chart which we quantify by using our Pulse indicator.

When the Pulse indicator plots a green bar on the upside like it did last week, it indicates that the stock is between a 2 and 3 standard deviation move on the upside. In other words, price is overbought. It doesn’t mean price can’t move higher, but it does mean it’s not statistically probable to do so. Less than 2.1% of all occurrences will fall outside of this range on the upside.

With this in mind, we are looking to sell an out of the money call spread which would take advantage of the stock either chopping sideways, or even selling off to the downside.

Trade Breakdown

To put on this trade, we used the October monthly options that have 27 days left to expiration. We sold the 145/150 call spread for $1.55 or $155 per spread. This meant we sold to open the 145-call and bought to open the 150-call at the same time.

By trading 2 options at the same time, we are left with a risk defined trade. The risk on the trade is limited to $345 per spread. This is the amount of capital required per spread to put the trade on.

If we are dead wrong and the stock moves higher instead of lower, the most we can lose is $345 per spread and that only happens if we hold all the way to expiration. We can always close the trade early and take the partial loss.

The $1.55 that we collected to open the trade is the max profit on the trade. If the stock crashes lower over the next few weeks, our profit will be capped at $155 per spread.

Trade Outlook

We make money on this spread if the stock moves up, down, or sideways as long as price stays below $146.55. The beauty here is we have a much more forgiving bearish trade on when compared to buying a long put. The long put would give us a bearish trade but would only leave us with one way of making money. The stock would have to move lower quickly in a big way.

Instead, the stock can just chop sideways or drift higher or lower and we can still make money. While we are giving up the home run profit potential that the long put would give us, in exchange we get a much higher probability of success since we have these 5 ways of making money.

We also make money from every day passing since the time decay will be working our favor. Finally, we make money if volatility decreases. All 5 of these factors will help the spread get cheaper and will allow us to buy the spread back to close the trade for less than what we sold it for to open the position.

5 Ways of Making Money

1. We make money if the stock moves up as long as the stock price stays below $146.55.
2. We make money if the stock moves down as long as the stock price stays below $146.55.
3. We make money if the stock moves sideways as long as the stock price stays below $146.55.
4. We make money from every day that passes since the time decay is helping us.
5. We make money from volatility decreasing.

Trade Management

The max profit potential on this trade is the $1.55 or $155 per spread that we collected when opening the trade. The only way we get to keep this $155 is if we hold all the way to expiration. We don’t like to hold this long.

Instead, we will look to close the trade when we can keep between 50-75% of the max profit potential. This has us looking to close the trade for between $.38-$.77. If we can close the trade out for $.38 sometime over the next few weeks, it would leave us with a profit of $117 per spread. This would give us with a 34% return on our capital.

If the trade moves against us to the upside, we will cap our loss at 70%. This will allow us to limit the damage on the losing position.

Conclusion

We love this type of trade as it allows us to put on a bearish trade but with a much more forgiving position. Instead of needing to be perfectly right on direction and time like we would have to be with a long put, we are able to use a trade that gives us 5 ways of making money.

Booking a 34% return on capital in less than a few weeks can add up to a nice return over time. These credit spreads have produced a very high winning % for us over the years. It’s not uncommon to see 70-75% win rates on these trades due to their forgiving nature.

Don’t get caught focusing exclusively on trading long calls and puts in all markets. While they are powerful trades that we use in some cases, they are also the most aggressive trade you can take.

You will see better consistency over time if you add in the vertical spreads, specifically the credit spreads. They will allow you to put on a high probability trade, while being in a fully risk defined trade.

This will help lower the stress level from your trading over time.