| Before I delve into my thoughts on how we can take advantage of the current state of the market I want to tell you about an article I read a few weeks ago. It was one of the most insightful articles I've read in years. If you truly want to become a savvy investor, you shouldn't miss out on this one. Yes, it's that good. Jason Zweig is the personal finance columnist for the Wall Street Journal's Intelligent Investor. His weekly column is on my shortlist of must-reads. A few weeks ago he justifiably won a Gerald Loeb Award, the most prestigious in business journalism. Jason's way of thinking is often in-line with my own…although admittedly he often does a better job portraying his thoughts in a concise and easily-digestible manner. Although, to my own defense, he isn't an options trader burdened with the difficulty of explaining one of the most misunderstood aspects of investing. Believe me, I'm not complaining. But I digress. Here is the article in full. Loyal readers of The Strike Price will quickly pick up on the similarities between Jason's approach and my own. Click here to read. For those of you who wish not to read Jason's article, I want to present to you a snippet of his article as a lead-in to what I'm about to tell you. From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance. But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity. My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors' own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing. – Jason Zweig As we all know the market has once again taken off. So much so that Thursday marked the first time in the history of the S&P 500 ETF, SPY, gapped up at least 0.5% for four of the past five trading days, while simultaneously closing at a 52-week high. If we take out the "while simultaneously closing at a 52-week high", there were 13 times the SPY gapped 0.5% higher four out of five trading days. Out of the 13 occurrences, nine led to declines over the following week. So, over the short-term we should expect to the broad market benchmark (SPY) struggle. Of course, this falls in line with one of my favorite indicators, the RSI.  Just look at the chart above and you can quickly see by glancing at the RSI just how far we've moved into an overbought state over several times frames (5) and (14). The both indicators are just a simple way to show the SPY has moved we have moved several standard deviations above the mean. Typically, when we see this type of extreme the market experiences a short-term reprieve. As always, I side with mean-reversion because I believe in mathematical finance. I believe investing should be viewed through the lens of statistics. I call it logical investing. Using mean-reversion to form a general idea and placing a high-probability strategy around that idea. It's what successful professional options traders have been doing for years and now it's finally a realistic approach for self –directed investors. So, the real question is…how can we take advantage of SPY's overbought state? I want to take advantage of mean-reversion by selling options with a high-probability of success. With SPY trading around $167.50 and knowing the current statistics lean towards a short-term decline I most often sell bear call spreads. Yes, you could buy some straight up in-the-money puts to take full advantage of a potential short-term decline and I sometimes will take that approach although with a smaller then average position-size. But my preference is to sell vertical spreads, in this case a bear call spread, with a high-probability of success. Let me explain. A bear call spread is a credit spread composed of a short call at a lower strike and a long call at a higher strike. The nature of call pricing structure tells us that the higher strike call we are buying will cost less than the money collected from the sale of a lower strike call. It is for this reason that this spread involves a cash inflow or credit to the trader/investor.
The ideal condition is for the spread to expire worthless, thus allowing you to keep the premium collected at the time of the sale of the spread. In order for this to happen, the underlying will have to close below the lower strike call option that you are short.
The basic premise of the strategy is easy: you choose the probability of the trade. Increasing the probability of success will decrease your potential profits, but will increase your likelihood of success. So, with SPY recently surging to over $167.50 and into a very-overbought state, again statistics lean towards a pullback, at least temporarily. So now, I want to choose a short strike for my bear call spread that meets my risk/return objectives.
I prefer a win rate/probability of success in the 70%-95% range. The high-probability rate doesn't give the same rate of a more aggressive high-probability rate of say 55%, but I prefer a more conservative approach with a higher win ratio. As such, I might invest in the Aug13 173/175 bear call spread.
I like to give myself a decent margin for error, which obviously increases my probability of success. For example, the 173 strike allows for a $5.45 or 3.2% cushion to the upside. The Aug13 SPY 173/175 bear call spread met my expectations as it brought in a credit of approximately $0.30 or $30 per contract. As a result: SPY would have to move above $173.30 for the trade to start losing value. As long as the stock price stays below $173.30 through August options expiration the trade is successful. Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders' tool belt. Final Note of Interest: There have been three other times the Nasdaq 100 gapped up and had an intraday low least +1% above the previous close, then managed to close at a 52-week high. All three preceded immediate corrections of 5% or greater during the next month. The dates were 3/22/00, 7/7/03 and 1/4/10. – Jason Goepfert As always, if you have questions, feel free to drop me a line at optionsadvantage@wyattresearch.com.
Editor's Note: We're happy to announce the latest in a long line of highly-popular webinars presented by options expert, Andy Crowder -- "How to Consistently Double Your Income Even in a Flat Market". During this free, live event you'll learn exactly how to generate monthly income -- DOUBLE what you earn now -- in up, down, and even sideways markets. You'll also receive step-by-step trade recommendations including: a bonus AAPL trade for taking advantage of Apple's upcoming earnings call and profiting right away! It all starts Thursday, July 18th at 1 p.m. ET. So, be sure to reserve your seat now. Click here to register. Kindest,
Andy Crowder
Editor and Chief Options Strategist Options Advantage and The Strike Price Twitter: @optadvantage | 
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