Bear Call Spread

The bear call spread is an income producing strategy you set up when you don't expect a stock to trade above a certain level.

Bear Call Spread Overview

The bear call is similar to the bull put spread but instead of acting to insure someone else's stock from a drop in share price, you're insuring someone else's stock from a rise in share price.

That may sound a bit odd, but not everyone desires, or profits from, a rising stock.

The bear call spread consists of simultaneously selling an out of the money call option and buying another out of the money call option but at a higher strike price. This produces a net credit.

The maximum gain is the total amount of net credit received if the share price finishes below the lower strike price (i.e. that of the short call).

The maximum loss is the difference between the two strike prices minus the net credit received. The maximum loss is triggered when the share price ends above the higher strike price (i.e. that of the long call).

As with the bull put, there are three variables in a bear call:

• What price above which you're betting the stock won't trade (strike price)
• How long the coverage period is (expiration date)
• How much income or compensation you collect (net premium).

Bear Call Example

The XYZ Zipper Company is trading at $28/share.

The company is facing headwinds in that some questionable photos have surfaced on the internet involving the new CEO.

You've seen the photos on the internet yourself (what kind of sites do you visit when you're not learning about options, by the way?). In short, you feel quite confident that the stock won't be trading above $30/share any time soon.

You check out the option chain on the stock and decide to employ a bear call spread option trading strategy.

You simultaneously sell a call option at the $30 strike price with an expiration date two months out for $1/contract, and purchase a call option at the $32.50 strike price with the same expiration date for $0.50/contract.

Excluding commissions, you receive a net credit of $0.50/contract, or $50 ($1 less $0.50 multiplied by 100).

Bear Call Spread Scenarios

The possible outcomes:

• The stock closes below $30/share - Both call options expire worthless and your profit is the full amount of your original net credit. In this example, that's $50, or a 20% return ($50 divided by the $250 initial capital required, which is calculated by the difference between the $30 and $32.50 strike prices).
• The stock closes between $30/share and $32.50/share - The $32.50 call expires worthless, but the $30 call finishes in the money. Your original net credit is reduced by the amount the $30 call is in the money (i.e. above $30/share). Because of the $0.50 initial net credit, you don't actually begin losing money until the stock climbs above $30.50/share.
• The stock closes above $32.50/share - You lose the maximum amount possible on this trade, in this case $200. You lose $250 on the difference between the strike prices (both options expire in the money), but because ot the initial $50 in premium you received at the outset, your maximum loss is only $200.

Bear Call Spread Variations

#1. It should be noted that a bear call spread is essentially a naked call with much needed protection added to it.

In fact, the naked call is probably the riskiest and most dangerous option trade of all. So much so that it's unlikely your online broker would ever authorize you to trade it. With a naked call, your potential losses are theoretically unlimited.

In contrast, the bear call spread caps your losses to the difference between the strike prices of the trade. That's a huge difference.

#2. By adding a bull put spread on the same stock with the same expiration date as your bear call spread, you turn the position into an iron condor.

The iron condor produces maximum income/gains as long as the stock closes within the trading range determined by the two components of the trade.

Pros and Cons of the Bear Call Spread

There are both advantages and disadvantages to the bull put spread.

Advantages

The first benefit, as mentioned above, is that the bear call spread limits your potential loss to the difference between the strike prices of your short and long call option.

If you were crazy and reckless enough to write naked calls (and if your online options broker was crazy and reckless enough to allow you to write naked calls), theoretically, there's no limit to how much you lose if the stock rockets higher.

The second benefit is that your capital requirements are minimal compared to how many shares and how much market capitalization you're actually controlling.

Compared to a reckless and stupid naked call position where you would need to hold enough cash in your account to buy 100 shares of the underlying security in the open market if the stock ever traded above your chosen strike price, the bear call spread in the example above requires only $250 in capital per spread.

The Serious Drawback

As with the bull put spread, the primary drawback here is that it invites abuse as the temptation to over leverage becomes too much to resist.

The twin benefits described above, when aggressively exploited, can easily be turned into a lethal, self-sabotaging, wrecking machine.

Let's assume that you sold a single naked call contract with a $35 strike price. That implies you've got $3500 lying around as collateral. And that figure rises as the share price rises.

But in our example above, where there's only $2.50 between strike prices, each spread position requires just $250 in collateral. For the same $3500, you could set up more than 10 times the number of contracts.

There's no advantage, however, to limiting your losses to $250 per contract if you just end up multiplying your positions by a factor of ten (maybe you're not the kind of person who does such a thing, but from personal experience, I can attest to the fact that I am).

Loading up on these kind of spreads is abusing a limited risk option trading strategy until it becomes a high risk option trading strategy.

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