<< Basic Option Spread Strategies (Part 3) - Bull Put Spread

Bear Call Spread

Step 1: Sell lower-strike Call option
Step 2: Buy high-strike Call option at the same expiration date

Characteristics
A Vertical Spread, this is a Credit Transaction

Investor Sentiment
Moderate Bearish Strategy (large credit spread):
It’s considered a bearish strategy because you profit if the underlying stock price decreases.

Income, Profit & Loss
New credit = Lower-strike call options – higher-strike call options
Profit = Net credit received (maximum, limited)
Loss = Difference between strike prices – net credit (maximum; limited)

Profit Potential
Maximum profit achieved if the stock price closes below the lower-strike (short) call option strike price on the expiration date.

Risks
Maximum loss occurs if the stock price increases above the out-of-the-money, long (higher) call option strike price at the expiration date.

Drawbacks
Limited profit potential, but lower risk than strictly buying naked call options. Break even at lower strike price plus net credit. Similar to a Bull Put Spread, this strategy is a credit spread position. That is, the amount of the sale of the call option position brings in more than is required to buy the long one.

How To Trade
Many traders regard this trade an income strategy. You trade a bear call spread in circumstances where you anticipate the underlying asset price to either decline or at least not rise above the level of the lower-strike price selected. You are looking for very strong resistance such as a confirmed double top or head-and-shoulder and other technical reversal patterns.

For Bear Call Spread to work as a short-term strategy, you generally want to select both strike prices to be above the current stock price and the spread between two strikes to be tighter – say one strike price apart.

Time decay is helpful in this position and the safest period to trade is one month to expiration date. This will give the opposite side of the trade little time to be right.

Bear Call Spread Example

Stock Company Name/Ticker Symbol: American International Group, Inc (AIG)
Stock Price: $60.55
Sell Near-The-Money Call Option (Short Position): 10 contracts - Nov $60 @ $2.65
Buy Out-Of-The-Money Call Option (Long Position): 10 contracts - Nov $65 @ $0.80
Call Options Expiration Date: November (Third Friday of the month)

This position is considered a net credit of $1.85, for spread of $5. That is the difference between the sale of the lower-strike (short) call option and the purchase of the higher-strike (long) call option which results in a positive cash flow of $1.85 ($2.65 - $0.80). The spread represents the difference between the short option and long option strike prices, which are $5 apart (Nov $65 call option - Nov $60 call option). So, what does all of this translate to for potential profit? Let’s assume the stock price is lower than the short (lower) call option strike price ($60) on November expiration date. That would translate to a maximum profit of the net credit we received when we established the Bear Call spread ($2.65 - $0.80) = $1.85 x 10 contracts (1,000 shares) for a maximum profit of $1,850. The percentage return becomes $1.85/$5.00* x 100% = 37%. (*$5.00 as denominator because you would need to keep this amount as margin before you can execute this trade.)

Now let’s look at the maximum loss potential should the stock price go above the out-of-the-money (higher) strike price on the November expiration date. Our Bear Call Spread pre-determines the maximum amount we are willing to lose. The maximum loss would be the difference in call strike prices or “spread” minus the net credit received. In our example, this translates to $5.00 - $1.85 = $3.15 x 10 contracts (1,000 shares) = $3,150.

By using the Bear Call Spread strategy we have lowered our risk compared to only selling naked calls. If we sold the November $60 @ $2.65 call option naked and the stock price closes higher than $60 on November expiration date, we would have a potentially unlimited loss. This is a much more significant loss than the potentially limited loss using the Bear Call Spread strategy.

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