A bear call spread is also referred to as the vertical spread. It consists of calls having the same expiration but with different strike prices. The strike price of a call option which is near the spot price is shorted. And the strike price which is further away from the current price, is bought. Doing such a transaction creates a net credit and is collected as premium.
The purpose of selling a call is to generate income, whereas the purchased call simply limits the upside risk.
In this strategy, the profit depends on how much of the initial premium is maintained by us before the option expires. As the name suggests, the strategy gives the best result when the stock stays below the lower strike price. An unexpected rise in price will also not expose us to unlimited loss. Loss is limited, so is the profit. Let us try to understand better with the help of an example.
A Bear Call Spread example
Let us say IBM is trading at $55. To implement a bear call spread, you should sell a call option with a strike price of $60. Along with this, you should buy a call option with strike price $65. The premium collected for a sold option is $3, and the money spent on purchasing the call option is $1. Therefore the net credit will be $2, which is the difference between the two premiums.
The maximum profit is only the net premium received. The commissions are always deducted from profits. This profit is only realized if the underlying security stays at or below the sold call option until expiration. Both the calls need to expire worthlessly.
The maximum risk in this strategy is the difference between the two strike prices minus the net credit received. Commissions can also be added. In the above example, the difference between the strike prices is $65 minus $60, which is equal to $5. The net premium received is $2. Therefore the maximum risk is $5 minus $2, which is equal to $3. You need to pay this maximum amount if the stock expires above the strike price of the purchased call at expiration.
The break-even point will be the strike price of the sold call option plus the premium received.
In this example: $60 + $2 = $62.
Profit/Loss diagram illustration
Impact of volatility
Volatility is a measure of the change in the stock price over a period of time. Volatility also determines option prices. Keeping other factors constant as volatility rises, option prices also rise. Since a bear call spread involves two call options at the same time, it is seen that the price of the spread changes very little to change in the volatility. In the language of, options this means a “non-zero vega”. Vega gives the change in option prices as the volatility changes.
Impact of time
The time value of an option decreases as the expiration approaches. In options, it is known as time erosion. The sensitivity of bear call spread to time erosion depends on the relationship of stock price to the chosen strike price. If the stock remains near or at the strike price of a shorted call option, then the price of spread decreases with the passage of time. This is because the sold call option erodes faster than bought call option. However, if the stock crosses and stays above the bought call option, then the price of the spread increases with the passage of time. This is because the long call option erodes faster than sold call option. If the stock price is somewhere at the midway of the two strike prices, then time erosion does not have much effect on the price of the spread. As in this case, both the options will erode at the same rate.
When to use a bear call spread
It is better to use this strategy when you are moderately bearish on the stock in the near term
Use a bear call spread under the following scenarios:
- When the stock is going to go down, and there is no more upside left in the stock.
- The stock needs to go down before the expiration date. It will be of no use if it goes down after several weeks.
- The stock should also not drop significantly. You will still make money. But to get the maximum benefit from the strategy, it should stay just below.
Pros and Cons of a bear call spread
- Lower risk – Your loss is always limited in this strategy because you have created both long and short positions in the stock.
- Instant profit – If you can take advantage of time value, then this strategy will give you an immediate return.
- Strike price selection – Choosing the right strike is critical in this strategy. If you choose a strike price that is too close to the stock price, then you would end up losing money.
- Reduced return – If you get damn right, and the stock drops drastically, your reward will be very less, as you could have made much more if you were not using this strategy.
- A Bear call spread is a popular strategy among investors who have a neutral to bearish view on the stock.
- Bear call spreads have defined risk and defined reward.
- The impact of time decay depends on whether the option strike is in the money (ITM) or out of the money (OTM)
- Profits can vary for a short term expiry and a long term expiry.
- There are various other combination strategies which can be used along with this strategy. This is done to turn losing trades into winning trades. But they don’t work every time and involve additional risk. It can only be attempted by professionals.