Normally, I’m an avid fan of the bear call spread. It provides a higher probability alternative to other negative delta trades due to its wider profit range. You’re gaming time decay while betting options are overpriced.

But sometimes, the reward just doesn’t seem to be worth the risk.

Like right now.

SPY Posture

The S&P 500 has officially retraced 50% of its bear market plunge. That means it is exactly in the middle of its February 19th peak and March 23rd low. From a risk-reward perspective, we have to say bear trades are favored here over bulls due to how overbought stocks have become. But it’s not a slam dunk! SPY is now in a short-term uptrend with multiple accumulation days (e.g., high volume up days) signaling institutions are wading back in the waters.

Nonetheless, let’s suppose you want to build a bearish options trade. Long puts are out because the VIX is still north of 40. That means they’re too expensive. The simplest alternative is to either use bear calls or bear puts.

Bear Calls

High POP, Low Reward, High Risk

With SPY @ $278, I can sell the May $305/$310 bear call for 74 cents credit. The short call has a delta of 0.15 which grants me a probability of profit of 85%. Not bad for an ROI of 17.4%.

But here’s why I’m not in love with the trade.

First, the SPY has a sky-high ATR of $12. That means my short strike is only slightly over two ATRs away. But it expires in 35 days! Does that sound like an adequate buffer? Not really!

Second, consider the most likely outcomes over the next month. I think we either continue ripping higher on the heels of unprecedented government/Fed stimulus and optimism that the end of the pandemic is nigh. Or, we drop back into the abyss as the reality of a deep recession kills the perception of a quick recovery.

For a bear call, I’m risking a lot ($4.26) to make a little (76 cents). That’s not exactly the kind of payout I want when faced with this environment. If the market plunges, the bear call doesn’t provide that big of a payday. But if I’m wrong and we continue ripping, the bear call takes a substantial hit.

The biggest argument in favor of the bear call would be the belief that the market is going to meander sideways for a few weeks but I’d argue that’s the least likely scenario.

Bear Put

Instead of selling the May $305/$310 bear call, what if we purchased the May $265/$260 bear put spread? It offers a lower POP, but lower risk and higher reward versus the bear call. Here are the spread metrics:

Cost/Risk: $1.23

Max Reward: $3.77

Probability of Max Profit: 29%

In an environment of extremes, this one seems far better. If the market tanks, I have the potential for a 300%+ profit. If SPY skyrockets then I’m only out $1.23. And because of the extremely high ATR, I think the odds of dropping to $265 or $260 sometime over the next month is high. So the probability of a profit is far higher than the 29% probability of max profit mentioned above.

The one scenario where I’ll wish I did the bear call is if SPY treads water, and I just don’t see that as the most likely outcome here.

I’ll talk more about this comparison, complete with risk graph visuals to better enhance our understanding in this weekend’s Options Report.

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