Bear Call Spread in the XIU Market

The stock market has rallied a long way from the March lows. The iShares S&P/TSX Equity 60 ETF (symbol XIU) is up almost $8 from that scary day on March 23, 2020 when the market reached bottom.

The rally has been steady, with few pullbacks.

However, it is completely natural to expect that, eventually, there will be a correction.

Using Fibonacci analysis, we can get a sense of the levels to which XIU might pull back. For context, Fibonacci analysis is anchored in the belief that the magnitude of a market correction is directly related to the magnitude of the prior market rally.

Chart 1: iShares S&P/TSX Equity 60 ETF (symbol XIU), 1-year chart

 Source: Bloomberg

It is not unusual for markets is to retrace 50% of the move. In this case, such a pullback would bring XIU back down to $21.31.

If an investor was bearish, one method to express that view would be to purchase a put. The investor might choose the December $25 put for $1.28 per contract (prices as of August 24, 2020). If XIU falls to the 50% retracement level of $21.31 by the December expiration, the contract will be worth $25 – $21.31 = $3.69, for a profit of $2.41 per contract.

However, another method of expressing a bearish view would be to enter into a bear call spread. In this case, the investor would:

SELL the December $21.50 call for $3.82 per contract (prices as of August 24, 2020)

BUY the December $25.00 call for $1.08 per contract (prices as of August 24, 2020)

As long as XIU expires below $21.50, the position nets a profit of $2.74 per contract.

However, the most the investor can lose is $0.76, since the long call position limits the potential loss from the short call. As such, the $3.50 difference between the strikes represents the maximum loss, which is reduced by the net premium received of $2.74.

Chart 2: Profit and loss chart over time of the bear call spread

 Source: Bloomberg

At the 50% retracement level, the long put position results in a gain of $2.41 versus the investor’s $1.28 at risk. This contrast to the bear call spread position results in a gain of $2.74 versus the $0.76 at risk at expiration in December (prices as of August 24, 2020).

Obviously the bear call spread seems to be the better choice, but that begs the question: why would an investor ever choose to implement the straight put purchase?

We have assumed that the market stops at the 50% retracement level. If it were to decline further ─ let’s say all the way to $20 ─ then the profit on the put would jump to $3.72, while the bear call spread is limited to a maximum gain of $2.74 at expiration in December (prices as of August 24, 2020).

Therefore, it makes sense to use a bear call spread when an investor is confident about the maximum amount of the projected decline, or does not wish to hedge past that amount.

Either way, the bear call spread is a valuable weapon to add to an investor’s arsenal.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.