Stock options provide traders with a great way to speculate on future price direction in a way that generates very specific risk-to-reward profiles. While bullish traders could simply purchase a stock outright, stock options enable them to build leveraged positions that involve limited losses. Spread strategies, in particular, provide a very specific maximum loss and maximum profit for each trade.
In this article, we’ll take a look the bear call spread strategy and how it can be used to speculate on a decline in an underlying stock’s price.
Be sure to read our introductory article Options 101: American vs. European vs. Exotic.
What Is a Bear Call Spread?
A bear call spread—also known as a credit call spread—is a bearish options strategy that creates a net cash inflow at the onset. By purchasing a long call option and writing a short call option at a lower strike price, the strategy generates an immediate income with a limited gain and loss profile. The limited-risk, limited-reward strategy is ideal in situations where traders are cautiously pessimistic.
The strategies key prices to remember include:
- Maximum Gain – The maximum gain occurs when the stock price falls below both call option strike prices, which results in both options expiring worthless and the initial credit encompassing the profit.
- Maximum Loss – The maximum loss occurs when the stock price moves above the higher strike price, which results in a loss equal to the difference between the two strike prices minus the net credit received.
- Breakeven Point – The breakeven point occurs when the stock price is above the lower strike price by the amount of the initial credit received, which would result in the long call expiring worthless and the short evening out.
Bear Call Spread Example
Suppose that a trader believes that a stock will fall after its earnings announcement, but he or she isn’t confident enough to short the stock outright or use simple put options. By simultaneously buying an SEP 50 call for $100 and selling an SEP 45 call for $300, the trader establishes a bear call spread and receives a net $200 credit for entering the trade – the difference between the two premiums.
If the stock falls to $44.00 at expiration, as expected following a poor earnings announcement, both options will expire worthless and the trader will keep the entire $200 net credit received at the onset as a profit. If the stock rises to $52.00 instead, both calls expire in the money and the trader will have to buy back the spread for $500, which translates to a $300 loss after the $200 credit.
Bear Call Spread Dynamics
The bear call spread strategy is ideal in situations where traders are cautiously pessimistic given its limits on profit and loss potential, but there are many different ways to make the strategy profitable in different situations.
For example, traders can enter a more aggressive bear call spread by expanding the difference between the two strike prices. These dynamics will increase the initial credit received and thereby the maximum profit potential, although the stock price must move down to a greater degree in order to realize that profit, which introduces more risk on the part of the position as a whole.
The Bottom Line
The bear call spread strategy is a bearish strategy that’s optimal for traders predicting a moderate decline in price. With its controlled profit and loss profile, traders know exactly how much they can gain or lose on the trade, which sets it apart from riskier strategies like naked puts or short selling. The other key benefit is that the credit is realized upfront and can be reinvested in other trades.
- Best Stock Advisor – Is Motley Fool’s Stock Advisor the Best Investment Advice Service? - September 21, 2020
- 8 Best Stock Advisor Services and Stock Picking Websites - September 21, 2020
- Motley Fool Stock Advisor vs Rule Breakers – Which is the Best Stock Picking Service? - September 14, 2020