Bear Call Spread

A bear call spread setup involves selling one call (at or near the money) and buying one higher-strike call (further out of the money) at the same time.  Having two different strike contacts in the order creates a spread.

When selling this spread at trade entry, the trader is obligated (if the buyer exercises their contract) to sell (or sell short) the underlying shares at the strike price of the call that was sold.  The trader also has the right to buy the same shares at the purchased call’s higher strike.  By spreading the trade, the user has limited their potential losses to the difference between the two strikes.

Since the trader risks having to sell shares at a lower price than the price the trader has the right to buy the same shares, the trader is compensated for the risk by receiving a premium at the time of trade entry.  This premium is the difference between the sold call’s credit and the bought call’s cost.

The bear call spread is frequently used by beginner and seasoned options traders alike.  It is often used in combination with bull put spreads in a single portfolio to make the portfolio more neutral in it’s direction.  This bear call spread, when optimized as part of an overall strategy, allows the trader to take advantage of decaying options while limiting their risk at tradeoff of higher potential profits seen in a short call setup, which has unlimited risk and not suitable for many investors.

This setup is particularly well suited for small brokerage accounts and those with limited options trading permissions.

A bear call spread will have a break even price between price ‘A’ and price ‘B’.  You can find an example break even price designated as point ‘C’ in the graphic above.  It is calculated by taking price ‘A’ and adding the premium received at trade entry.

The ideal outcome is for the stock price to remain below strike price ‘A’ at expiration.  In this case, the call seller keeps the all the premium received and the option expires worthless.  The trader is then free to repeat or move on to a new trade.

Max profit is limited to the premium received at trade entry.

The trader of the bear call spread is obligated to sell the shares at strike price ‘A’ if the buyer chooses to exercise their right in the option contract.  However, in this setup, the trader also has the right to buy shares at price ‘B’.  This limits the potential losses to the difference between ‘A’ & ‘B’ strike prices less the premium you received at trade entry.  Having fixed losses in an options position is often referred to as a ‘defined risk’ trade.

The broker will require you set aside the maximum loss that could be experienced in the trade, defined above.

As the trader has received more credit from the sale of the first call at strike price ‘A’ than required to purchase the call at strike price ‘B’, the trade has ‘time on their side’.  This means that as time passes and the underlying stock remains at or below price ‘A’, the trader will see slow and steady profits up to the point that they keep all the premium received at trade entry.

If implied volatility of the option increases, this will have an impact on call pricing.  It is expected that you will see the call with strike price A increase more in price than strike price B.  Therefore, the bear call spread trader could see losses if implied volatility increases (expands) and accelerated profit if implied volatility decreases (contracts).  For this reason, we try to use the bear call spread in medium to high volatility environments.

The bear call spread is a great strategy for those looking for defined risk and interested in playing both sides of the market (i.e., to be bearish) while still benefit from premium selling.  Key advantages include:

1. Suitable for beginner to advanced traders
2. Defined risk and great for small accounts
3. High probability of success (albeit, less than a short call setup)
4. Allows trader to express a view that the stock will decrease in value. Note participation in this direction is historically too difficult and risky for the average retail trader to participate.