Bear Call Spread

| March 20, 2012 | 0 Comments

Bear Call SpreadA bear call spread is a bearish options strategy.  You would use it only if you expect the underlying stock will drop in price.

In a bear call spread, you buy a call option at a certain strike price and sell a call at a lower strike price.  Since a call with a lower strike will always carry a higher price than a call with a higher strike and the same expiration, the bear call spread is a credit spread.

In other words, when you put on a bear call spread, you will receive a net credit in your account.  This is important because the net credit will be your profit if the position works as planned.

You see, the plan is for the stock to drop in price and force both call options to expire worthless.  In that scenario, you wouldn’t have to pay anything to close the spread and you would keep the net credit as your profit on the trade.

I know this sounds complicated.  Let’s take a look at a hypothetical example for more clarification.

Let’s say Microsoft (MSFT) stock is trading at $22 per share, the MSFT October 20 call is at $3, and the MSFT October $25 call is at $1.  Let’s further assume you create a bear call spread by buying the October $25 call and selling the October $20 call.

Your net credit from this transaction is $2 ($3 – $1).  This is also the maximum profit you can earn on this position.

Here’s why…

Under the best case scenario, MSFT would be trading below $20 at expiration and both options would expire worthless.  If that happens, you get to keep the $2 credit as your profit on the trade.  Of course, your total profit is really $200 as each option controls 100 shares of the underlying stock.

The worst case scenario is just the opposite.

MSFT would be trading above $25 at expiration and you would have to buy back the call option you initially sold to close out the spread.  The maximum amount this spread could expand to is 5 points (the difference between the two strikes).

So, the most you would have to pay to buy back the spread would be $5.  And your maximum potential loss would be just $3 (the difference between your net credit and the amount paid to close out the spread).

The break-even point, maximum profit potential, and investment required are all fairly easy to calculate:

Maximum profit potential = Net credit received

Breakeven point = Lower strike price + Amount of credit

Maximum risk = Collateral investment required = Difference in strike prices – Credit received + Commissions

In the above example…

The net credit you received from the sale of the October $20 call and the purchase of the October $25 call is $2.  So, your maximum profit potential is $2.

The breakeven point is the lower strike price, $20, plus the amount of the credit, $2, or $22.

Your maximum risk is equal to the amount of your investment.  You calculate it by taking the difference between the two strike prices – 5 points – and subtracting the net credit received – 2 points – for a total investment of 3 points plus commissions.

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Category: Options Trading Strategies

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.