Introduction To The Bear Call Spread Option Strategy
The bear call spread is a strategy that involves buying a higher-strike call option and selling a lower-strike call option, with both options derived from the same underlying security and having the same expiration date. The strategy aims to profit from moderate price declines within the remaining life span of the options.
Considerations to make when choosing a bear call spread(credit spreads)
- The profit on bear call spreads depend on options expiring worthless. Hence, traders often use options with fast erosion of time value. Some traders insist on using options with 45 days or less to expiration. By selecting such options, the traders give the underlying security less time to move into a position where assignment may occur.
- Traders who execute a bear call spread try to select options which result in a high net credit. The higher the net credit or premiums collected, the greater the maximum profit.
- The more astute traders insist in the option having a small difference in the exercise prices. This is done to minimise risk. Traders further validate that the trade is worthwhile by dividing the maximum profit over the maximum risk to find out the risk and reward ratio. A high risk and reward ratio is always better than a low risk and reward ratio.
- The breakeven point should be within the trading range of the underlying security so that the trade can move into a profitable position more easily.
Lower commissions
A bear call spread is classified as a credit spread. As such, the trader can allow the options to expire worthless without closing the trade. That is, commission costs are saved in a bear call spread. This is more evident when compared to debit spreads such as the bear put spread. Debit spreads such as the bear put spread usually involves higher commissions paid as the trade is closed out. In a nutshell, credit spreads usually involve lower commissions paid than debit spreads.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Moderately Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited potential losses
Step 7 : Calculate Loss
Step 8 : Limited potential profit
Step 9 : Profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Executing the bear call spread
Step 12 : Exiting the bear call spread
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
It is important to know the general direction of the market and the underlying security over the life of the bear call spread which is executed. To do so, one must be able to gauge market direction through economic analysis and perform fundamental analysis to understand the near term risks of the underlying security. With regards to fundamental analysis, adepts will be able to foretell a dividend cut or an impending earnings decline that may materialise in the near term. Last but not least, perform technical analysis to determine optimal entry and exit points. Some chart patterns that the options trader can look out for is:
Read : Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook – Moderately Bearish
A trader that uses the bear call spread is moderately bearish and projects a moderate price decline over the remaining life of the options. A moderately bearish projection refers to a small directional decline of the price of the underlying security.
Step 3 :Study the option chain
Examine the option chain and select the options to construct the bear call spread. A bear call spread requires one to look at the call options in an options chain.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The breakeven price point can be calculated as exercise price of the ITM call + net premiums collected (credit received)
At this price point, the trade is neither profitable or loss making.
Step 5: Understand Your Profit Zones
After performing breakeven analysis, the trader is able to understand where the zone of profitability is. The idea in this case is that the price of the underlying security should move below the breakeven point in order for a profit to be made. This visualization can be made by drawing the image shown above.
Step 6 : Limited potential losses
If the price of the underlying security is greater than the exercise price of the long OTM call, the trader will suffer a maximum loss.
Step 7 : Calculate Loss
That maximum loss is limited and can be calculated as :
Difference between the exercise price of the OTM call and the ITM call – premiums collected (credit) + commissions paid to broker
Step 8 : Limited potential profit
When a trader executed a bear call spread, a credit is received which is the difference between the premium collected from the short ITM call and the premium paid for the long OTM call. This credit received, which is also referred to as “net premiums” collected is the maximum profit that is realisable from this strategy. This profit can only occur if the price of the underlying security is less than or equal to the strike price of the short call. In this way, all the options involved in the spread expire worthless.
Step 9 : Profit calculation
Net credit from bear call spread – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
Next, one should calculate the risk and reward ratio. Ascertain that the risk and reward ratio is comparable or better than other trades.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Executing the bear call spread
For every in the money call that is shorted, an out of the money call is bought. Hence the ratio of shorted in the money calls to long out of the money calls is 1:1.
Step 12 : Exiting the bear call spread
- If the price of the underlying security rises above the long exercise price, the short call becomes in-the-money. The option trader(initiator of the bear call spread) has the obligation to sell the underlying security to the option holder. This occurs when the option buyer exercises the right to buy. The long call can be exercised to buy the underlying security. This will result in the maximum loss.
- If the price of the underlying security trades between the higher exercise price and the breakeven point, the short call is assigned. The option trader(initiator of the bear call spread) may have the obligation to deliver the underlying security to the option holder by purchasing the underlying security at current market prices. A loss will result. The option trader can sell to close the long call to reduce the loss.
- If the price of the underlying security trades between the breakeven point and the short exercise price, the short call is assigned. If it is exercised by the option buyer on the other side of the trade, the option trader(initiator of the bear call spread) has to sell the underlying security to the buyer of that option by first buying the underlying security at current market prices. A loss results. The option trader can sell the long call to reduce losses.
- If the price of the underlying security falls below the exercise price of the short call, all the options expire worthless. The maximum profit is realised by the trader. This is the best case scenario.
Step 13 : Record Trade In Diary
After the bear call spread has been exited, the trader should record the trade in a diary. This aids in the reflection process. Analysis can be performed on the trades to refine trading process and increase profits in future trades.
Example Of A Bear Call Spread
The price of TMART Corp is trading at $42. A trader is bearish on the company and decides to execute a bear call spread by buying a current month OTM July 45 call and selling a July 40 ITM call. The July 45 call cost $1 while the July 40 call cost $3. As a result, $2 of net premium is collected as a form of credit to the trading account.
$3 – $1 = $2
$2 x 100 = $200
The total premium collected(credit to the account) is $200.
When the price of TMART trades at $35 on the expiration date of the options, the options expire worthless as they are out of the money. Hence, the maximum profit is the credit of $200 collected when the trade was executed.
If the price of TMART trades at $48 on expiration date, the long call is closed out at a profit of: $3 – $1 = $2 as its ending value is $3 ($3 in the money) and the short call is closed out at a loss of : $8 – $3 = $5 (ending value of the short call is $8 as it is $8 in the money). Hence, the total loss is : $5 – $2 = $3
Another way to look at the maximum loss is:
Difference between the exercise prices of the 2 calls – net premiums collected =
$5 – $2 = $3
$3 x 100 = $300
Hence, the maximum loss is $300.
In conclusion, a bear call spread has limited profit potential but also a limited loss potential. It is to be used in projections of moderate declines in the underlying security prices.
Modifications to bear call spread to capture greater profit
If a trader is more bearish on the underlying security and wants to capture a greater profit, he can create an aggressive bear call spread with a wider difference in the option exercise prices.
Bear call credit spread vs bear put debit spread
A bear call is a credit spread which means that a credit of premiums is received as one enters the trade. The bear put spread is a debit spread which means there is a net premium paid to enter the trade. A credit is addition to the trading account while a debit is a deduction from the trading account. In both cases though, the projection is a bearish prediction on the underlying security.
Bull Call Spread & Bear Call Spread Used To Create A Condor
A bull call spread and bear call spread is used to create a short condor.
Read : Short Condor : Profit From Increased Volatility & Executing A Bull call spread