What is a bear call spread?
A bear call spread is a popular trading strategy among option traders. It represents a type of vertical spread, which means that it is traded with the help of two call options with the same expiry date.
How does a bear call spread work? A trader sells one option, which gives him a credit. Then he buys another call option, which serves as a protection against an adverse asset’s price movement. Usually the price of the sold call option is closer to the stock price than that of bought call option.
The bear call spreads are often used when the trader is slightly bearish – they expect a decline in the price of the underlying asset.
Where have you heard of bear call spread?
Bear call spreads are popular trading instruments often used by income investors with a neutral or bearish perception of a stock price movement. As bear call spreads are considered as trades with a predefined risk and predefined profit, they are often traded within retirement investment accounts.
What you need to know about bear call spreads.
Often called a short call spread, a bear call spread has one major advantage – the risk of the trade is reduced. It means that when you buy a call option with a higher strike price, it helps to offset the risk of selling a call option with a lower strike price. Therefore, the maximum loss with bear call spreads is the difference between the two strikes, reduced by the amount credited at the trade initiation.
So, what is a bear call spread? To make it clearer, let’s take a look at a simplified example below:
Imagine you’re going to trade a stock with a share price of $200 through a call option with a strike price at $205 for $5 and a call option with a share price of $195 for $10.
To implement a bear call spread you do the following:
- buy the $205 call option and pay a $5 premium, and
- sell the $195 call option and make a $10 premium.
After both options reach their expiration date, they are exercised. If by that time the stock price is equal or falls below $195, neither option will be exercised and you'll get $5 as a credit from the initial options trade. This is the best scenario.
If the price climbs higher or equal to $205, both options will be executed and your profit will comprise the $5 from the initial trade, a loss of (price - $195) from the sold option and a gain of (price - $205) from the bought option. In this case you'll get -$5 per share, with means a loss of $5.
Trading bear call spreads may become an ideal option if you believe that the price of a chosen asset will fall by a certain limited amount between the trade and the expiration date. However, if the price of the underlying asset nosedives further, a bear call spread trader loses the opportunity for additional profit. The limits of the possible losses and profits from bear call options are defined according to the strike prices of the implemented call options.
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