Timing market bottoms is a challenge. Even armed with an abundance of indicators and fundamentals, everyday investors and professionals alike can often leave frustrated.
One major issue is timing an entry. Investors who are on the sidelines and want to dip their toes back into the market without taking a lot of risk can consider using bull call spreads on their favorite stocks or indices.
In this example, we will explore using a bull call spread on SPDR S&P 500 ETF.
Constructing Bull Call Spread On SPY
To construct a bull call spread, simultaneously buy a call and sell a call at a higher strike price with the same expiration. For SPY ETF, investors can consider buying a 405 call while selling a 415 call, both with a Jan. 20 expiration.
To place the trade investors will pay a debit of $4.80 a share. This coincides with a maximum loss of $480 for a block of 100 shares should SPY trade below 405 on expiration. The maximum gain is the width of the strikes (the 415 call minus the 405 call) minus the debit paid. In this case, a maximum gain of $520 (10-4.80 x 100) will be realized if SPY ETF is above 415 on expiration.
An attractive feature of the bull call spread is investors know exactly how much they can lose and are off the hook if the market collapses once again to new lows. The negative is in a sharp V-shaped recovery the bull call spread also limits gains.
With the market already rallying significantly after signs that inflation has peaked, some continued follow-through is certainly possible through the coming weeks. Also traditionally over the Christmas season, the market has historically experienced muted trading with a slightly higher bias.
Traders Must Watch For Inflation Risk
Nevertheless, any signs against this growing consensus — foremost if inflation once again surpasses expectations — and the market could easily spiral to new lows.
This example on SPY ETF could be used on any stock an investor is bullish on, as long as their options chains are liquid. For larger cap stocks such as Apple, Home Depot, JPMorgan Chase and Tesla, this should be no issue.
For smaller stocks not included on the S&P 500 or trading under 10 a share, bull call spreads should be avoided due to the added transaction costs.
The S&P 500 is down 15% year to date but has topped its 50-day moving average and is now trading right at its 200-day moving average.
IBD's market timing model looks for a follow-through signal to get back into stocks after a market correction. That signal most recently came in October, and IBD's current outlook is "market in confirmed uptrend."
