bear call spread example

bear call spread example

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From Wikipedia, the free encyclopedia

In options trading, a bear spread is a bearish, vertical spread options strategy that can be used when the options trader is moderately bearish on the underlying security.

Because of put-call parity, a bear spread can be constructed using either put options or call options. If constructed using calls, it is a bear call spread. If constructed using puts, it is a bear put spread.

A bear call spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying call options of a certain strike price and selling the same number of call options of lower strike price (in the money) on the same underlying security with the same expiration month.

Consider a stock that costs $100 per share, with a call option with a strike price of $105 for $2 and a call option with a strike price of $95 for $7. To implement a bear call spread, one buys the $105 call option, costing $2, and sells the $95 call option, costing $7. The total profit after this initial options trading phase will be $5.

After the options reach expiration, the options may be exercised. If the stock price ends at a price P below or equal to $95, neither option will be exercised and your total profit will be the $5 per share from the initial options trade.

If the stock price ends at a price P above or equal to $105, both options will be exercised and your total profit per is equal to the sum of $5 from the original options trading, a loss of (P - $95) from the sold option, and a gain of (P - $105) from the bought option. Total profits will be ($5 - (P - $95) + (P - $105)) = -$5 per share (i.e. a loss of $5 per share). The loss is due to speculation that the price would go down but it actually did not.

A bear put spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying higher striking in-the-money put options and selling the same number of lower striking out-of-the-money put options on the same underlying security and the same expiration month. The options trader hopes that the price of the underlying drops, maximizing his profit when the underlying drops below the strike price of the written option, netting him the difference between the strike prices minus the cost of entering into the position.

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Bearish Option Strategies » Bear Call Spread

When your feeling on a stock is generally negative, bear spreads are nice low risk, low reward strategies.

One of the easiest ways to create a bear spread is by using call options at or near the current market price of the stock.

Like bear put spreads, bear call spreads profit when the price of the underlying stock decreases. Bear call spreads are typically created by selling at-the-money calls and buying out-of-the-money calls.

Using the Nasdaq-100 Index Tracking Stock (QQQQ), we can create a bear call spread using in-the-money options. With QQQQ Trading at $30.11 in May, you might buy ten of the JUL 32 calls and sell ten JUL 30 calls.

With the underlying stock trading near $30, you'd sell the 30 calls for $1.85 and buy the 32 calls for $1. This way, you'd initiate the spread for a credit of $850, your maximum profit. If the stock moves lower, both calls will expire worthless and you'll keep the $850 premium you collected when you initiated the position.

A bear call spread, or a bear call credit spread, is a type of options strategy used when an options trader expects a decline in the price of the underlying asset. Bear call spread is achieved by purchasing call options at a specific strike price while also selling the same number of calls with the same expiration date, but at a lower strike price. The maximum profit to be gained using this strategy is equal to the difference between the two strike prices, minus the net cost of the options.

BREAKING DOWN 'Bear Call Spread'

For example, let's assume that a stock is trading at $30. An option trader can use a bear call spread by purchasing one call option contract with a strike price of $35 for $0.50 and a cost of $50 ($0.50 * 100 shares/contract) and selling one call option contract with a strike price of $30 for $2.50 or $250 ($2.50 * 100 shares/contract). In this case, the investor will earn a credit of $200 to set up this strategy ($250 - $50). If the price of the underlying asset closes below $30 upon expiration, then the investor will realize a total profit of $200 (($250 - $50) - ($35 - $30 * 100 shares/contract)).

Advantages of a Bear Call Spread

The main advantage of a bear call spread is that the net risk of the trade is reduced. Selling the call option with the higher strike price helps offset the cost of purchasing the call option with the lower strike price. Therefore, the net outlay of capital is lower than selling a single call outright. And it is carries far less risk than shorting the stock or security since the maximum loss is the difference between the two strikes reduced by the amount received, or credit, when the trade is initiated. Selling a stock short theoretically has unlimited risk if the stock moves higher.

If the trader believes the underlying stock or security will fall by a limited amount between trade date and expiration date then a bear call spread could be an ideal play. However, if the underlying stock or security falls by a greater amount then the trader gives up the ability to claim that additional profit. It is a tradeoff between risk and potential reward that is appealing to many traders.

With the example above, the profit from the bear call spread maxes out if the underlying security closes at $30 —the lower strike price —at expiration. Closes below $30 will not result in any additional profit. Closes between the two strike prices will result in reduced profit while closes above the higher strike, $35, will result in a loss of the difference between the two strike pRices reduced by the amount of the credit received at the onset.

Max profit = $200 (the credit)

Max loss = $300 (the $500 spread between the strike prices minus the initial credit)

The bear call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term.

The bear call spread option strategy is also known as the bear call credit spread as a credit is received upon entering the trade.

Sell 1 ITM Call

Bear call spreads can be implemented by buying call options of a certain strike price and selling the same number of call options of lower strike price on the same underlying security expiring in the same month.

The maximum gain attainable using the bear call spread options strategy 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 expiration date where both options would expire worthless.

The formula for calculating maximum profit is given below:

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

The underlier price at which break-even is achieved for the bear call spread position can be calculated using the following formula.

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

Suppose XYZ stock is trading at $37 in June. An options trader bearish on XYZ decides to enter a bear call spread position by buying a JUL 40 call for $100 and selling a JUL 35 call for $300 at the same time, giving him a net $200 credit for entering this trade.

The price of XYZ stock subsequently drops to $34 at expiration. As both options expire worthless, the options trader gets to keep the entire credit of $200 as profit.

If the stock had rallied to $42 instead, both calls will expire in-the-money with the JUL 40 call bought having $200 in intrinsic value and the JUL 35 call sold having $700 in intrinsic value. The spread would then have a net value of $500 (the difference in strike price). Since the trader have to buy back the spread for $500, this means that he will have a net loss of $300 after deducting the $200 credit he earned when he put on the spread position.

Note: While we have covered the use of this strategy with reference to stock options, the bear call spread is equally applicable using ETF options, index options as well as options on futures.

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

One can enter a more aggressive bear spread position by widening the difference between the strike price of the two call options. However, this will also mean that the stock price must move downwards by a greater degree for the trader to realise the maximum profit.

The bear call spread is a credit spread as the difference between the sale and purchase of the two options results in a net credit. For a bearish spread position that is entered with a net debit, see bear put spread.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks". [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

This options strategy can be used to profit in a down market.

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The opposite of buying stock is shorting. The purpose of this strategy is to profit if the stock declines in value. However, shorting involves significant risk, as a stock can go up indefinitely; your potential loss is technically unlimited.

If you think a stock is overpriced and might decline, the bear call spread is a strategy that can facilitate trading this expectation, while limiting the associated risk. 1

Why choose the bear call spread

A bear call spread involves selling a call with a strike price at or above the current market price and purchasing another call with a higher strike price. This creates a position for which the potential loss is limited, compared with a naked short position, which has unlimited loss potential. The trade-off for limiting risk of loss is that there is a limit to your potential profits.

The bear call spread is similar to the bear put spread: Both strategies anticipate a decline in the underlying stock. The obvious dissimilarity is that calls, instead of puts, are purchased and sold, but the key difference is that a bear call spread is a credit spread. That is, you take in income at the outset of this trade. On the other hand, the bear put spread is a debit spread; you pay at the outset of the trade.

Which strategy should you implement? You may want to assess the maximum potential profit and loss of both to determine which one to use if you expect the underlying price to decline. Fortunately, both strategies allow you to identify the maximum potential profit or loss in advance.

The bear call spread’s maximum profit is the net credit received, and the maximum risk is the difference in the strike prices less the net credit received at the outset. Alternatively, the bear put spread's maximum potential profit is the difference in the strike prices less the net cost of the trade, while the maximum risk is the initial cost of the spread.

You can consider the implied volatility of the options, relative to their historic volatility, to help you make a determination as to which strategy to use:

  • If implied volatility is relatively high, it may be advantageous to be in a net credit position (i.e., you may get more value from selling options as opposed to buying). Thus, a bear call spread might be more attractive.
  • Alternatively, if implied volatility relative to historical volatility is low, a net debit position (i.e., a bear put spread) may be more attractive.

How to construct a bear call spread

Normally, you will use the bear call spread if you are neutral or moderately bearish on a stock. Your goal is for the underlying stock to remain below the strike price of the sold call.

To construct a bear call spread, you would:

  • Sell a call with a strike price at or above the current market price. The purpose of selling a call is to take in income. By selling a call with a strike price at or above the current market price, you are anticipating that the stock will not rise above the strike price, and thus it will expire worthless, so you can keep the premium.
  • Buy a call with a higher strike price. The purpose of buying a higher strike call is to protect against a large increase in the price of the underlying stock. Obviously, purchasing a call reduces the net credit you take in, but it serves to protect from significant potential losses if the stock rises well above the current market price.

This spread effectively allows you to potentially profit if the stock declines in value (by keeping the income from the sold call, less the cost of the purchased call), while limiting your potential loss in the event that the stock rises in value.

If the stock does rise, the potential loss could be partially offset by the credit taken in at the outset of the trade. Also, if the stock rises above the strike price of the purchased call, losses on the sold call will be offset by gains on the purchased call, assuming the stock price rises significantly.

Before initiating the trade—what to look for:

Preparation is very important when trading options. Here are some general guidelines that you may want to follow before entering into a bear call spread:

  1. Find a good candidate. The most important component of making a successful bear call spread trade is identifying a stock that you expect to fall in price.
  2. Pick a price. After you've chosen the security that you expect a decline in value, you need to decide at which strike prices to buy and sell. For example, for a stock trading at $27, you may choose to sell a 30 call and buy a 35 call. A larger spread typically increases the profit potential, but the wider difference in premiums might increase your risk exposure, as well as increase the margin requirements of the trade.
  3. Pick a date. Next, choose an options expiration date that matches your expectation for the stock price to fall. Remember, the further out the expiration date, the greater the premium that you will probably take in. However, a later expiration date increases the window of opportunity for the option to be exercised, and thus, the risk of early assignment and the option being exercised at a loss. Keep in mind that ex-dividend dates and earnings announcements can play a significant role in the trade.

Assessing the potential risk/reward characteristics of each of these choices is crucial when assembling the bear call spread. One way this can be accomplished is by analyzing options greeks—particularly the delta of the sold call. The delta provides an approximate probability of the contracts expiring worthless and, thus, the likelihood you will be able to keep the credit.

An example of using greeks would be a short call that has a delta of 30. This tells you the short call has a 70% probability of expiring out of the money (i.e., not being exercised). A profit/loss probability graph can be constructed easily using the P/L calculator on Fidelity.com. Below is a graph of Fidelity’s profit/loss calculator showing these probabilities.

A profit/loss graph displaying the probability of options being exercised.

Now that you have a basic idea of how this strategy works, let's look at a hypothetical example to get a better sense of it.

Assume that in June, you believe XYZ—currently trading at $31—will fall to $30 over the next two months. You decide to initiate a bear call spread.

  • This could be done by selling an XYZ August 30 call (this position would be referred to as a short call) for $3 per share, resulting in the receipt of $300 ($3 x 100). At the same time, you buy an XYZ August 35 call (long call) for $1 contract, paying out $100 ($1 x 100). The maximum potential profit is the difference between the credit you receive ($300) and the debit you pay out ($100) to construct the position. Thus, the maximum profit on this position is $200 ($300 – $100), less commission and fees, which, for simplicity, we will not consider in this example.

Your total income, or credit, at the outset of this trade is $200 ($300 – $100). The goal of the strategy is for the stock to decline in value so that you get to keep the entire $200 premium.

However, if the stock price rises, your position is subject to potential losses. Recall that the maximum potential loss for a bear call spread is the difference in the strike prices (in this example, 35 – 30) times the number of shares controlled by the contract (100), less the credit received at the outset of the trade ($200). Thus, the maximum loss on this trade is $300 ([5 x 100] – 200).

Now, let's assume the price moves in several directions. If the underlying stock remains at $30 or remains lower during the life of the contract, both options expire worthless and you get to keep the $200 profit.

If the stock rose to $35 and the 30 sold call was assigned, your loss on the position would be $300. This is calculated as the share price increase ($5) times the total number of shares controlled by the one contract (100), less the net credit received for constructing the position ($200). Note that even if XYZ rose above $35, your loss would still be $300 because any additional losses on the sold call would be offset by gains on your purchased call.

Given that the underlying stock price can move in either direction during the life of the contract, it is possible to actively manage your trade to lock in profits or prevent further losses.

One way this can be done is by repurchasing the sold option in the open market to effectively lock in the position. In our hypothetical trade above, suppose in July the stock has increased to $31 a share and you believe it could continue to rise. To cap your losses on the position, you could buy to close the XYZ August 30 call, which would offset the call you sold at the outset of the trade.

With some experience, you may be able to more effectively manage this trade. So, if you are neutral or moderately bearish on a stock and would like to limit your risk exposure, consider the bear call spread.

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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.

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