A bear call spread is a two-part options strategy that entails selling a call option and receiving an upfront option premium, followed by acquiring a second call option with the same expiry date but a higher strike price. One of the four fundamental vertical option spreads is a bear call spread.
Because the strike of the sold call (the short call leg) is lower than the strike of the bought call (the long call leg), the option premium received in the first leg is always more than the cost paid in the second leg.
Because the commencement of a bear call spread leads in the receipt of an upfront premium, it is sometimes referred to as a credit call spread or, alternatively, a short call spread. This method is often used to produce premium revenue based on a pessimistic outlook of a stock, index, or other financial instrument held by an options trader.
Which Vertical Option Spread Should You Use?
Profiting from a Bear Call Spread
A bear call spread is a risk-mitigation technique that is comparable to purchasing call options to protect a short position in a company or index. However, since the asset sold short in a bear call spread is a call option rather than a stock, the maximum profit is limited to the net premium received, while the maximum profit in a short sale is the difference between the price at which the short sale was completed and zero (the theoretical low to which a stock can decline).
As a result, a bear call spread should be considered in the following trading scenarios:
- When a trader anticipates a stock or index to fall by a little amount rather than a large amount, this method is suitable. Why? Because if a significant decrease is expected, the trader would be better suited adopting a strategy such as a short sale, purchasing puts, or launching a bear option spread, where the potential rewards are substantial and not limited to the premium earned.
- Volatility is high: A high degree of implied volatility translates into a higher amount of premium revenue. Even while the short and long legs of the bear call spread help to mitigate the effect of volatility, the reward for this approach is higher when volatility is high.
- Risk reduction is required: A bear call spread limits the potentially limitless loss that a naked (i.e. uncovered) short selling of a call option allows. Keep in mind that selling a call obligates the seller to deliver the underlying asset at the strike price. Consider the possible loss if the underlying security rises two, three, or ten times before the call expires. Thus, although the lengthy leg of a bear call spread decreases the net premium that the call seller (or writer) may make, the expense is entirely justified by the large risk reduction.
Bear Call Spread Example
Consider the following hypothetical stock: Skyhigh Inc., which claims to have produced a new aircraft fuel additive, recently hit a high of $200 in turbulent trading. Legendary options trader “Bob the Bear” is negative on the stock, and although he believes it will plummet to earth at some time, he believes it will first meander downward. Bob would want to profit from Skyhigh’s volatility in order to make a greater income, but he is worried about the stock’s potential for further rise. As a result, Bob launches the following bear call spread on Skyhigh:
- Sell five contracts of $200 Skyhigh calls that expire in one month and are now selling at $17.
- Purchase five contracts of $210 Skyhigh calls, which expire in one month and are now selling at $12.
- Bob’s net premium income is $2,500 since each option contract represents 100 shares, or ($17 x 100 x 5) – ($12 x 100 x 5) = $2,500
To keep things simple, commissions are not included in these samples. Consider the following situations in the closing minutes of trade on the option expiry date a month from now:
Bob’s prediction comes true, and Skyhigh is now trading at $195. The $200 and $210 calls are both out of the money and will expire worthless in this situation. As a result, Bob is entitled to the whole $2,500 net premium (less commissions).The optimal case for a bear call spread is when the stock drops below the strike price of the short call leg.
Skyhigh is now selling at a price of $205. In this scenario, the $200 call is in the money by $5 (and is now trading at $5), but the $210 call is out of the money and hence worthless.
To meet the obligation deriving from the execution of the short call, Bob has two options: (A) close the short call leg at $5, or (B) purchase the stock in the market for $205. Option A is preferred above Option B because Option B would need extra commissions to acquire and distribute the shares.
Closing the short call leg at $5 would require a $2,500 investment (i.e., $5 x 5 contracts x 100 shares each contract). Because Bob earned a net credit of $2,500 when the bear call spread was initiated, the total return is $0. As a result, Bob makes a profit on the deal but is out of pocket to the amount of the fees paid.
Skyhigh’s assertions about jet fuel have been proven, and the stock is currently trading at $300. In this scenario, the $200 call is $100 in the money, while the $210 call is $90 in the money.
However, since Bob is short the $200 call and long the $210 call, his net loss on his bear call spread is: [($100 – $90) x 5 x 100] = $5,000.
However, since Bob earned $2,500 when the bear call spread was initiated, the net loss = $2,500 – $5,000 = -$2,500. (plus commissions).
How’s that for risk reduction? Instead of a bear call spread, Bob could have sold five of the $200 calls (without purchasing the $210 calls) and lost $50,000 when Skyhigh was trading at $300: $100 x 5 x 100 = $50,000.
Bob would have suffered a comparable loss if he had sold short 500 shares of Skyhigh at $200 without purchasing any call options to mitigate risk.
Bear Call Spread Calculations
To summarize, the following are the essential calculations connected with a bear call spread:
Maximum loss = difference in call strike prices (long call strike price less short call strike price) – net premium or credit received + commissions paid
Net Premium or Credit Received – Commissions Paid = Maximum Gain
When the stock trades at or above the strike price of the long call, the maximum loss happens. In contrast, the highest profit is realized when the stock moves at or below the strike price of the short call.
Break-even = Short call strike price + Net Premium or Credit Received
The break-even point in the above case is = $200 + $5 = $205.
Bear Call SpreadAdvantages
- In comparison to selling or writing a naked call, the bear call spread allows premium revenue to be produced with less risk.
- The bear call spread capitalizes on time decay, which is a powerful aspect in options strategy. Because most options expire or are not exercised, the odds are stacked in favor of the bear call spread creator.
- The bear spread may be customized to a person’s risk tolerance. A more cautious trader may choose a tight spread where the call strike prices are close together, since this reduces both the maximum risk and the maximum possible gain of the position. An aggressive trader may want a wider spread to maximize profits, even if it means taking a larger loss if the price rises.
- A bear call spread will have fewer margin requirements than selling naked calls since it is a spread strategy.
Bear Call Spread Disadvantages
- Gains with this options strategy are relatively restricted, and may not be sufficient to warrant the risk of loss if the approach fails.
- The short call leg is at high danger of being assigned before expiry, particularly if the stock rises significantly. This may require the trader to purchase the stock in the market at a price considerably over the strike price of the short call, resulting in a significant loss immediately. This risk is magnified if the strike price gap between the short and long calls is significant.
- A bear call spread works best for equities or indexes that have high volatility and may fall somewhat lower, implying that the ideal trading circumstances for this technique are restricted.
The Bottom Line
During turbulent times, the bear call spread is an excellent option strategy for earning premium money. However, since the dangers exceed the benefits, this approach should only be used by extremely knowledgeable investors and traders.
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