Within the same expiration month, the bear call spread is a vertical spread options strategy in which the investor sells a lower strike price call option, represented by point A, and buys a higher strike price call option, represented by point B. The investor will earn a premium or credit since the lower strike price call is more valuable than the higher strike price call.
An investor entering this trade has a potential profit that is limited to the premium they received when they executed the trade and a potential loss once the stock raises above their short strike price in an amount larger than the premium they received.
If the investor believes the market will remain flat or fall, they will employ this method. The higher call is used as a hedge in case the market trades higher, allowing the investor to limit their maximum loss.
The Bear Call Spread Strategy
The bear call spread is an options strategy that works by allowing the options to decay gradually day by day until the expiration date, resulting in both options expiring worthless and the investor keeping the entire premium.
- It is better to use the approach when it is anticipated that a stock will trade sideways or fall in price.
- This method is popular among many traders and is appropriate for all investors since it allows them to implement a high probability trade with minimum risk.
When implied volatility is high, the vertical call spread is most effective because option pricing rises, allowing the trader to earn a bigger premium on the deal.
Profit/Loss
The maximum profit an investor can expect from this trade is the credit or premium obtained. If the stock closes below the lower strike price at expiration, the investor will earn the most.
- The maximum loss can be estimated by subtracting the premium received from the difference between the two strike prices. On the expiration date, the stock price must end above the higher strike price.
- In general, if short calls expire in the money, the trader will be assigned the stock position upon expiry. When calls go deep into the money, though, there is always the possibility of early assignment.
Breakeven
The breakeven point for a bear call spread is the lower strike price plus the trade cost.
Breakeven = short call strike + premium received
Example
A Rs.2 55-60 call spread consists of selling a 55-strike price call and purchasing a 60-strike price call. If the stock stays below the strike price of 55, the Rs.2 premium represents the maximum win.
With a Rs.5 wide strike width (60 -55), the maximum loss is Rs.3, less the premium earned to enter the transaction, in our example Rs.2, leaving the investor with a maximum loss of Rs.3.
If the vertical has both strikes in the money, time will work against the investor since they will want this trade to continue, giving them more time for the stock to plummet in price.
Conclusion
This is a wonderful strategy to adopt if an investor believes a stock is trading sideways or lower but is unsure of the timing or wants to provide themselves a buffer in case the market goes sideways or slightly up.
Many traders flocked to the bear call spread because of its high potential of success and little risk, but if the stock moves against them, they might lose significantly more than their initial investment. Those interested in executing a spread with a lesser probability of success but a far lower potential loss might consider the bear put spread or the bull call spread.
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