Below is a graphic that explains the risk/reward graph
for a directional, bull call debit spread, and the
recommended trading rules to use this type of
directional trade to protect/insure non-directional bear
call spreads. Directional trades, like the bull
call spread shown in this example, can be
used to periodically help us protect our credit
spreads during strong trending markets. In
this case, where we show a bullish trade that makes
money as the underlying index rises, this type of
directional trade would help insure our existing bear
put credit spreads from a strong UP trending market.
Below is the
risk/reward graph for a bull call spread on the Russell
2000 index - RUT.
Below is an
example to help us develop the
recommended rules to utilize a directional bull or bear
debit spread to protect an existing income generating bear
call spread. The same rules apply when
placing a directional trade to protect an existing bull put
spread if the market is trending DOWN.
a) When the
value of the existing bear call credit spread doubles in
value, using the mid-point between the bid/ask spread
b) When the 6
month/1 day bar and 60 day/30 minute bar volume and
advance/decline-based indicators show that the
underlying index is in a confirmed UP trend.
c) If the
8/22 EMA on the underlying index shows a confirmed UP
trend; i.e. if the 8 day EMA is above the 22 day EMA.
following above criteria are met, open 1 directional
bull call spread for every 10 open bear call spreads.
Let's look at
Let's say we
have qty 10 of the RUT May 770/780 bear call credit spread
and that the criteria above was met, and the underlying
RUT index is at 735. We would open the following:
Sell to Open
(STO) 1 RUT 760 call
Buy to Open (BTO)
1 RUT 740 call
Below is what
the existing RUT May 770/780 bear call credit spread
looked like when it was first opened on April 16, for a
credit of 55 cents. (which is a typical credit
that we'll bring in for a bear call spread)
Below is what
the RUT May 770/780 bear call credit spread looked like
after the close on April 22nd; we can see that the value
of the credit spread has increased to 90 cents, putting
it "under pressure". We first opened it for a 55
cents credit, or $550 for qty 10, and if we decide to
close it immediately it would cost 90 cents debit to
"buy it back" to close it, for a loss of 35 cents,
or $350 for qty 10.
Our goal with
our directional insurance trade is to make it increase
in value at the same rate that our original bear call
spread increases in value, and to devise a ratio to
achieve this. Below is the directional trade that
we decide to open on April 23rd at the opening bell, for
a debit of $640.
the value of the insurance, versus the value of the
original RUT May 770/780 bear call spread, as a function
of the price of the underlying RUT index to see if the
insurance can cover some or all of the loss as the RUT
increases in value. This analysis assumes that
volatility remains somewhat stable, which is probably
the case for the May 2010 cycle.