The bear call spread is an option trading strategy that is employed when you believe that the price of the underlying asset will fall at least moderately in the near term.
The bear call spread option strategy is also known as the bear call credit spread since a credit is received when entering the trade.
|Bear Call Spread Construction|
|Buy 1 OTM Call
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.
Limited Downside Profit
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 Short Call
Limited Upside Risk
If the stock price rise above the strike price of the higher strike call at the expiration date, then the bear call spread strategy suffers a maximum loss equals to the difference in strike price between the two options minus the original credit taken in when entering the position.
The formula for calculating maximum loss is given 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
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
Bear Call Spread Example
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 (+$8.95 per trade).
Aggressive Bear Call Spread
You 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.
Bear Spread on a Debit
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.