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.

If the following above criteria are met, open 1 directional bull call spread for every 10 open bear call spreads. 

Let's look at an example:

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.

Let's analyze 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.

To be continued.....