Bear Call Spread Explained



The bear call spread strategy should be traded when you think the price of the underlying asset will go down moderately in the short term.

Here’s how it’s constructed:

Buy 1 Out of The Money (OTM) Call – Sell 1 In The Money (ITM) Call

Bear call spreads are implemented by buying call options at a certain strike price and selling the same number of call options at a lower strike price of the same underlying security with the same expiration date.

Maximum Potential Profit

The maximum profit potential attainable using the bear call spread is the credit received upon entering the trade. To reach the maximum profit, the stock price needs to close below the strike price of the lower striking call sold at the expiry date, at which point both options will expire worthless.

To calculate the maximum profit potential of each bear call spread use the formula below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Call

Maximum Possible Loss

If the stock price rises above the strike price of the higher striking call at the expiration date, then your loss equals the difference in strike price between the two options minus the original credit taken when entering the position.

To calculate the maximum possible loss for each bear call spread use the formula below:

  • Max Loss = Strike Price of Long Call – Strike Price of Short Call – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Call

Breakeven

The underlying price at which the breakeven point is achieved can be calculated using the formula below:

  • Breakeven Point = Strike Price of Short Call + Net Premium Received

Bear Call Spread Example

Let’s say that Google (GOOG) stock is trading at $37 in May. You decide that this is overvalued and enter a enter a bear call spread position by simultaneously buying a JUN 40 call for $100 and selling a JUN 35 call for $300, giving you a net credit of $200 for entering the trade.

Fast forward 30 days and the price of GOOG stock has dropped to $34. Since both options will now expire worthless, you get to keep the entire credit of $200 as profit.

If on the other hand the stock had rallied to $42, both calls would have expired in-the-money with the JUN 40 call having an intrinsic value of $200 and the JUN 35 call having $700 in intrinsic value. The spread would then have a net value of $500 (the difference in strike price). Since you have to buy back the spread for $500, you’ll have a net loss of $300 after deducting the $200 earned when you entered the position.

Commission

For the sake of simplicity the above example neglects to include the relevant trade commissions. Ordinarily every trade you make will incur commissions from your broker. The amount you’re charged will vary from broker to broker but it’s usually in the region of $10 to $20. If you’re new to options trading the ideal broker to join is optionsXpress, as they have some of the best training around.

As your trading capital and experience grows you’ll probably want to start experimenting with some more advanced options strategies that include multiple contracts. For trades like this commissions can start to have a negative effect, since you’ll be making three or more contracts per trade. Fortunately there are brokers that specialize in this kind of trading. A good example would be OptionsHouse as they offer a low fee of only $0.15 per contract (+$8.95 per trade).

Conclusion

The bear call spread is an excellent first strategy for rookies to learn, since it only consists of two contracts and has a limited down side.

Just remember to try it out in a virtual environment first; you don’t want to be learning on the fly since one mistake can cost you thousands of dollars. Your virtual trading account is there for a reason so make use of it.




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