To start, let’s explain what a bear call spread is. A bear call spread represents one of four basic vertical spreads. It means using a type of options strategy that presupposes to sell the call option and at the same time to buy a different call option without changing the expiration date, but at a higher strike price. If the strike price of the sold call is lower than the purchased call price, the premium obtained for the sold call (usually named the short call leg), is higher than the premium paid for the purchased call (long call leg).
Traditionally, a bear call spread brings an upfront premium, therefore, it is also called a credit call spread, or a short call spread. The strategy is usually used to get the income out of the trader’s bearish opinion from the index, stock, etc.
Bear Call Spread in practice
Let’s assume that XXX stock trades at $37 in October. The options trader feels rather bearish about XXX price and makes a decision to open a bear call spread position and buy NOV 40 call for $100 and sell a NOV 35 call for $300, which gives him $200 credit for making this trade.
Finally, the price of the XXX falls down to $34 by the expiration date. It means, that both options became worthless and out of money, and the trader keeps the $200 credit as profit, making this the best scenario for the trader.
Well, let’s review the opposite situation when the stock price goes up and reaches $42 instead. It means that both our calls end up in the money. In this situation, the bought NOV 40 call will have $200 in intrinsic value, and the sold NOV 35 call will rise to $700 in intrinsic value. This time the spread, calculated as the difference in strike prices, will be $500. Going further, the trader should buy back this spread for $500, which means that he will have a net loss of $300 after using his $200 of the credit earned.
Note, that the example above doesn’t show the commission charges to help better understanding the essence of the concept. However, you should remember that the commission is an obligatory part of options trading and usually comprises relatively small amounts.
You should also remember that the maximum loss awaits you if the stock (or any other financial instrument) is traded at a higher price than the strike price of the long call. Vice versa, you can expect the maximum profit when the stock is traded at a lower price than the strike price of the short call.
What are the advantages?
- Bear call spread provides a real possibility to earn premium income and decrease the level of risk in comparison with selling an uncovered or naked call.
- Applying the bear call spread strategy you take the advantage of time decay, since the options value tends to decrease over time.
- You can tailor your bear call spread strategy to your own risk profile. If you are a moderate trader, trying to eliminate high risks, you can narrow the spread to keep the strike prices closer to each other. It will decrease the level of risk, but unfortunately the level of profit too.
- If compared with selling uncovered (naked) calls, bear call spread presupposes lower margin requirements.
And what do we know about the risks?
- You should realise that the profit you may gain from using this strategy is rather limited and not always enough to excuse the risk of loss.
- The bear call spread strategy is more preferable for indices and stocks with high volatility level.
Concluding, we’d like to admit that the bear call spread can be a good strategy to obtain premium income during the volatile period. Though, we must always remember, that the risks may surpass the gains, and this strategy is more suitable for experienced traders and investors.