Modules for Traders
Trading Strategies 1
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Bear Call Spread: Strategy Explained
What is a Bear Call Spread?
A bear call spread is a two-legged options trading strategy used when one’s market view is fairly bearish. Using this strategy, an investor sells a call option (short call leg) while simultaneously purchasing a separate call option (long call leg) with the same underlying asset and expiration date but at a higher strike price. Hence, one makes a net profit by receiving a higher option premium on the call sold than the amount paid towards the call purchased.
Since this strategy is used by options traders to generate premiums with a bearish view of a performance of the asset, it is popularly called ‘bear call spread’. However, when one initiates a bear call spread strategy, they receive their premium upfront. Hence, it is also known as ‘short call spread’ or ‘credit call spread’.
When is a Bear Call Spread Strategy Useful?
Now that we understand what is a bear call spread, here are some situations where this strategy might prove useful:
– Modest Decline Anticipated: If the trader expects a modest decline rather than a big plunge in the performance of a stock or index, a bear call spread strategy is ideal. This is because the potential gains from a relatively minimal decline are less and are restricted to one’s option premiums. If the decline were more extreme, the potential gains would be larger. Hence, it would be more appropriate to implement a bear put spread, short sale, or buying puts as trading strategies.
– High Volatility: Even though the long and short legs of the bear call spread tend to offset the shock value of volatility, this strategy pays off better when the market is volatile. This is because when implied volatility is high, one can generate more income from premiums.
– Managing Risk: Selling a call option exacts an obligation from the seller to deliver the security at its pre decided strike price. There is a huge potential for loss if that security’s market price soars to even double or triple before the call option expires. A bear call spread strategy puts a limit on the potentially massive loss on the uncovered short sale of one’s call option.,Although the long leg in this strategy reduces the premium amount the call seller can acquire, it substantially mitigates risk which justifies its cost.
Bear Call Spread Calculations
Here are some of the calculations associated with a bear call spread strategy.
Maximum loss:occurs once the stock or index trades at the strike price of the long call or above it.
Max Loss = Difference between the short call and long call strike price — Net Premium Received + Commissions Paid
Maximum Gain: occurs once the stock or index trades at the strike price of the long call or below it.
Max Gain = Net Premium Received — Commissions paid
Break-even= Short call Strike Price + Net Premium Received
Advantages of Using a Bear Call Spread Strategy
– You can earn options premium income with a lower degree of risk using a bear call spread strategy, as opposed to selling an uncovered call option.
– This strategy employs the principle of ‘time decay’ which is the decline in the value of an option across time. This is a crucial principle to incorporate in options strategy. Even if most options are not used or expire, the bear call spread originator continues to benefit as they have bought a call option at a higher strike price than they sold their previous one.
– The bear spread one chooses to opt is the difference between the strike prices of the short leg call and the long leg call. This spread can be tailored to fit one’s risk appetite. For instance, a somewhat conservative trader can opt for a leaner spread in which case the difference between the prices is minimal. This will diminish the maximum risk while also lowering the potential for maximum gain. On the flip side, a more aggressive trader might prefer employing a broader bear spread which will increase risk but also maximize gains.
– As a spread strategy, the bear call spread has fewer margin requirements as opposed to selling uncovered call options.
Limitations of Bear Call Spread
– Being a bearish strategy, the returns on a bear call spread can be limited and offset by its moderate to high risk.
– If the short call leg’s underlying stock rises rapidly, there is a significant risk of assignment on it. The trader might have no choice but to buy the stock at a much higher price than its strike price, resulting in a significant loss.
Optimal conditions during which it is appropriate to use this strategy – market volatility and the expectation for a modest decline in performance - tend to be limited.
Now that we understand the nitty gritties of Bear call Spread, let’s learn more about bear put spread in the next chapter.
A quick recap
- Bear call spreads are made by purchasing two call options, one long and one short, at different strike prices but with the same expiration date.
- Bear call spreads are considered limited-risk and limited-reward because traders can contain their losses or realize reduced profits by using this strategy. The limits of their profits and losses are determined by the strike prices of their call options.