A bear call spread is a type of option trading strategy that is used when a decrease in the price of the underlying stock is anticipated. This strategy is implemented by selling call options at a specific strike price and at the same time buying the same number of call contracts at a higher strike price. Investors profit from a bear call spread when the price of the underlying stock decreases.
In order to properly build a bear call spread strategy correctly, there are a few things to keep in mind. Here is a list of tips investors should understand before implementing this type of strategy.
Buy Out of the Money Calls
Sell In the Money Calls
Underlying Stock – All options bought and sold must be for the same underlying stock.
Same Expiration Date – The contracts that are sold and bought should have the same expiration date.
Same Number of Contracts – It is important to buy and sell the same number of option contracts when building a bear call spread.
Bear Call Spread Example
Initiating a bear call spread is easiest to understand by looking at an example. Let’s assume an investor believes that stock XYZ is going to decline in the coming months. In order to profit from this possible decline in market value, the investor plans to implement a bear call spread strategy.
The current share price of the underlying stock is at $23.23. The stock also has the following call options available to trade, which will help to build the strategy.
July $24 Calls – This out of the money option has an option premium of $.57.
July $23 Calls – This in the money option has a premium of $1.00.
Here are a few details of this hypothetical trade.
Buy 5 Out of the Money Calls – The investor purchases 5 of the July $24 calls at $.57 per contract. The investor will pay $285 (plus commission) to own these out of the money contracts.
Sell 5 In the Money Calls – The investor will then turn around and sell 5 of the July $23 calls at $1.00 per contract. As a result of the trade, the investor will receive $500 (less commission) for selling these in the money options.
The end result of the scenario above is the investor receives a credit of $215 (less commission) for initiating the spread.
There are a few possible outcomes of building a bear call spread strategy, like the example shown above.
Stock Price Moves Lower
If the stock price moves lower, which is what the investor is expecting, then both calls should expire out of the money. For example, if the share price of XYZ fell below $23 when the contracts expired, then both contracts would be out of the money. This means that neither holds any value, therefore they would more than likely expire worthless.
This is the best case scenario for the investor as they get to keep the entire credit of $215.
Stock Price Increases
The worst case scenario using this strategy is when the underlying share price increases above the strike price of the call options which were purchased. For example, if the share price of XYZ increased to $24.25, both types of options bought and sold initiating the spread would be considered in the money.
This is the worst case scenario for the investor, but one that offers limited risk. The maximum loss can be calculated by subtracting the difference between the strike prices of the two different contracts and subtracting the original credit received.
If we were to calculate this scenario for our example above, the maximum loss would look something like this –
Maximum Loss = (($24 – $23) * 5 contracts) – Original Credit
Since the investor traded 5 contracts, we must take the difference between the two strike prices and multiply it by the number of contracts times 100 shares per contract. The result is the potential for a $285 loss ($500 – $215), plus any commissions.
Stock Price Closes in Between
The last outcome possible for initiating a bear call spread is when the underlying share price closes between the two strike prices. For example, shares of XYZ could end up closing at $23.50 which is right in the middle of the calls that were sold at $23 and those that were bought at $24.
In this scenario, the long call contracts that were purchased would expire worthless as they are out of the money. At the same time, the calls that were sold would still be in the money by $.50 per contract. In this case, we would need to take the difference between the closing share price ($23.50) on the strike price of the short call ($23).
Here is how we would calculate the return or loss in this situation –
Total Loss = $215 – ($.50 * 5 contracts * 100 shares)
If the stock price were to close at $23.50 on the expiration date, the investor would lose $35 on the trade.
All scenarios described above do not take into account any commission or brokerage fees.
Initiating a bear call spread allows an investor to take advantage of downturns in a stock while minimizing any potential loss. The option strategy is implemented when an investor sells a call option(s) and then purchases the same number of contracts at a higher strike price. While the potential profit of this type of trade is limited to the initial credit received, the maximum loss is limited as well.