Option Trading Strategies: The Bear Call Spread

Posted 26. Feb, 2010 by Anthony in Stock Option Strategies

There are countless option trading strategies that allow you to tailor your own trading position by using a combination of stock options. You can have limited returns for limited risk, unlimited returns with limited risk, limited returns with unlimited risk or unlimited returns with unlimited risk.

There are option trading strategies that help you make money regardless of whether the market moves up, down or sideways.

One of the most commonly used strategies of this kind is better known as a spread.

While some spreads are generally directional, meaning you would have a bullish or bearish view on the market, and require a move in either direction, there are two that also allow you to profit when the share price remains neutral or moves sideways. One of these is:

The Bear Call Spread – can be used when you expect the share price to fall. You could just buy a put option and profit from a downward move, but if you got it wrong and the share price rose, your maximum potential loss is the total amount you paid.

The very appealing thing about a bear call spread is that it is a credit spread. That means you actually get paid when you implement this strategy.

To construct this type of spread you would write (sell) a call option slightly ‘out of the money’ and purchase a call option a little further out of the money (a higher strike price), both with the same expiry date. Your maximum risk is the difference between the two strike prices.

Here’s how it works:

Let’s say XYZ shares are trading at $ 45 and you were expecting them to fall. You could sell (write) a call option with a strike price at $ 46 and receive $ 2.50 in premium and you could buy a call option with a strike price at $ 47 for $ 1.80

So you have effectively been paid 70 cents for nothing! ($ 2.50 – $ 1.80 = 70 cents)

The maximum you would stand to lose if the position went against you is the difference between the two strike prices, in this case – $ 1.00

Here is what happens:

1. If the share price has fallen and is trading below the lowest strike price ($ 46) at the time of expiry then both options would expire worthless and the 70 cents is yours to keep.
2. If the share price is above the lowest strike price ($46) but below the highest strike price ($47), in other words it has moved sideways, at expiry then both options would expire worthless and the 70 cents is yours to keep.
3. If the share price is trading above the highest strike price ($47) at expiry then both the call options would be exercised and you would incur the maximum loss

In this case the maximum risk is the difference between the two strike prices, which is $ 1, but remember you were paid 70 cents for the trade, so your real risk is $ 1 – 70 cents = 30 cents

So you would be risking 30 cents in the hope of making 70 cents

*Brokerage fees have not been factored into any examples.

Related posts:

1. Option Trading Strategies: Insuring Your Shares
2. Stock Option Trading: Navigating the Roughest Terrain
3. Stock Options / Derivatives – Play it Safe

Tags: bear call spread options trading, bear market, Stock Option Strategies