Bear Call Spread Strategy

Reasons for Using the Bear Call Spread

The bear call spread is a strategy designed to be used when your expectation is that a security will fall in price, but not by much, and you want to generate profits from such a move. As we have mentioned above, it's a good alternative to the short call that will limit your potential losses if the security goes up in price instead.

You can also make a profit if the underlying security doesn't move at all in price, which makes this strategy a good choice if you don't have complete confidence that your bearish outlook is correct.

How to Implement

To implement this spread you must place two orders with your broker. You would usually look to place these orders simultaneously, but you can leg into the spread if you prefer. One of the orders you need to place is the sell to open order, to write calls based on the security you are expecting to fall in price. The second is the buy to open order, to buy the same amount of calls, based on the same security and with the same expiration date, but with a higher strike price.

Because the calls you are buying have a higher strike, they'll be cheaper than the ones that you write. As such, you will create a credit spread and receive an upfront payment.

You need to decide exactly which strikes your use for both sets of options. Typically, we would advise that you write calls that are at the money and buy ones that are out of the money. This way you will profit if the underlying security drops in price or if it stays the same. You could write in the money options instead, but you will then need a bigger drop in price to return a profit.

The larger the difference between the strikes of the call contracts you write and the ones you buy, the larger your potential profits will be and the more you stand to lose if the security goes up in price instead.

Profit & Loss Potential

The maximum amount you can profit from this strategy is the amount of credit you receive when implementing the trade. To make this maximum profit, you need the contracts that you write to expire either at the money or out of the money, making them worthless and therefore resulting in no liability for you.

This is why writing at the money contracts is a good idea, because you can make the maximum profit even if the underlying security doesn't fall in price and remains stable. If you have written in the money contracts, then you will need the price of the underlying security to fall below the strike of those contracts to make a profit. You do not make any additional profits if the price of the security falls by even more; your profit is still the amount of the net credit received.

If the underlying security increases in price, then this spread becomes a losing proposition. If the contracts you have written are in the money by expiration, then you'll have a liability, because you will need to either buy them back at a loss or they could be assigned. The amount you can lose is limited though, as if the price of the underlying security increases above the strike of the contracts that you own, then they will increase in value at a proportionate rate.

The maximum loss of the spread is therefore the difference between the strikes of the contracts written and the ones owned, multiplied by the amount of contracts written.

Advantages

The biggest advantage of this strategy is the flexibility it offers. You can implement it so that you can make a profit even if the underlying security stays the same, or you can implement it so that you need the price to fall but make a greater profit if it does. By adjusting the strikes in the contracts you buy and write you can achieve a risk to reward ratio that suits you.

Another advantage is that, although the maximum profit is limited, so is the maximum you can lose. By buying calls that are out of the money, you cap the amount you can lose should the underlying security go up in price and you incur a loss on the calls written.

Although this strategy is somewhat more complicated than a couple of the most basic alternatives, there's still only two transactions involved so the commissions are lower than some of the even more complex strategies that involve additional transactions. The calculations required to work out the maximum profit potential and maximum exposure to loss at the outset are relatively simple, so it's reasonably easy to work out exactly where you stand.

Disadvantages

Perhaps the biggest disadvantage is the fact that you can only make a limited amount of profit even if the underlying security falls dramatically in price. With a strategy such as the long put, you make more money the further the underlying security drops in price, which can obviously result in a much better return on investment.

Of course, the long put costs money to implement, as opposed to the upfront credit received from the bear call spread, so it is really a matter of weighing up the respective advantages and disadvantages.

The bear call spread also requires margin, which means tying up capital, and there's a risk that the options you write are assigned and you are obligated to sell the underlying security. This means first buying it, so you could end up paying a lot more in commission charges.

Example

Here we have provided a basic example of how a bear call spread might work in practice, with some hypothetical outcomes and the results. Please be aware this is just a theoretical example isn't based on real price movements and market events. Commissions haven't been factored in, for the sake of simplicity.

Initial Trade

• Company X stock is trading at $50, and you expect it to fall by a relatively small amount.
• At the money calls on Company X stock (strike price $50) are trading at $2 and out of the money calls on Company X stock (strike price $52) are trading at $1
• You write 1 call options contract with a strike price of $50 (each contract contains 100 options) for a credit of $200. This is Leg A
• You buy 1 call options contract with a strike price of $52 (each contract contains 100 options) at a cost of $100. This is Leg B.
• You have created a bear call spread for a net credit of $100.

If Company X stock decreases to $48 by expiration

The calls you have written Leg A expire out of the money, and are now worthless. The ones you have bought in Leg B also expire out of the money and worthless. With no further liabilities or obligations, you keep the upfront credit of $100 as your profit.

If Company X stock remains at $50 by expiration

The calls you wrote in Leg A expire at the money and are worthless. The ones you bought in Leg B are out of the money and expire worthless. The $100 upfront credit is your profit.

If Company X stock increases to $52 by expiration

The calls you wrote in Leg A expire in the money, and you will have a liability of around $2 per option written for a total liability of $200. The ones bought in Leg B will expire at the money and worthless. Your liability of $200 is partially offset by the $100 net credit received upfront, for a total loss of $100.

If Company X stock fell even further than $48, your profits wouldn't go any higher than $100, because the maximum profit you can make is the net credit received at the outset. If Company X stock went any higher than $52, your losses wouldn't go any higher $100. Although your liability for the options written in Leg A would increase, the price of the ones bought in Leg B would increase at the same rate.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security < or = Strike Price of Leg A”
• Maximum profit, per option owned, is “Price of Option in Leg A – Price of Option in Leg B”
• Maximum loss is limited.
• Maximum loss is made when “Price of Underlying Security > or = Strike Price of Leg B”
• Maximum loss per option owned is “(Strike Price of Leg B – Strike Price of Leg A) + (Price of Option in Leg A – Price of Option in Leg B)”
• Break-even point is when “Price of Underlying Security = Strike Price of Leg A + (Price of Options in Leg A – Price of Options in Leg B)”

Summary

This is a useful strategy if you are speculating on a quick, but small, drop in the price of a security and want to profit from that. There are risks involved if the stock goes up in price instead, but the spread does offer some protection against that. Profits are limited, but so are the losses, and this make makes it a suitable strategy if you have any worries that the security might increase in price rather than decrease.

Due to the complexities involved in this strategy, we would recommend that beginners instead consider other strategies.