Bear Call Spread

[Igor 10]

Traders who implement a bear call spread strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling two call options, hoping that both will expire out-of-the-money. Traders who employ this type of bear option strategy do not need cash to enter the trades and receive a credit when entering the market. The bear call spread limits both an investor's profit potential and their risk for losses.

 

Moneyness Review for Calls

Out-of-The-Money (OTM) = Strike price (more than) Market Price

In-The-Money (ITM) = Strike price (less than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

How to Carry Out An Out-Of-The-Money Naked Call Strategy

 

 

Disney stock is worth $37 (market price) in June.

1) Trader sells the call option: DISJul35($3)

- 100 shares of Disney stock

- Strike Price $35, in-the-money (ITM), expiring in 30 days

- Premium Cost of $3

2) Trader buys the call option: DISJul40($1)

- 100 shares of Disney stock

- Strike Price $40, out-of-the-money (OTM), expiring in 30 days

- Premium Cost of $1

3) Trader receives a $200 credit when entering the market. [$200 = $300 (received from call sale)- $100 (paid for call)]

Total cost to enter the market: -$200

 

Result one: Disney stock falls (crashes) to $28 in July.

a) The both of call option sold expires worthless. (OTM)

b) The trader's profits totals $200 after keeping the credit earned when entering the market.

 

Result two: Disney stock rises (rallies) to $42 in July.

a) The call option purchased expires ITM, and the trader exercises his or her right to buy 100 shares at $40 from the investor who sold the call, paying $4000.

b) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35.

c) The trader loses a total of $300 after adding the premium credit taken when entering the market to the loss. [-$300 = $4000 (paid for shares) - $3500 (received for shares) - $200 (credit to enter market)]

 

Result three: Disney stock remains at $37 in July.

a) The call option purchased expires worthless. (OTM)

b) The call option sold expires ITM.

c) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $3700.

d) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 the shares at $35.

e) The trader loses a total of $0 after adding the premium credit taken when entering the market to the loss. [$0 = $3700 (paid for shares) - $3500 (received for shares) + $200 (credit to enter market)]

 

Advantages and Disadvantages in Carrying Out A Bear Call Spread:

 

Pluses: The upside to this type of strategy is that investors do not need cash to enter the market and it limits the investor's potential for loss. They are betting that the asset's market value will crash and that both of the calls will expire OTM. This allows them to keep the credit earned when entering the market. Traders can also use the credit to offset losses in moderate bull markets.

 

Minuses: The downside in using a bear call spread happens when the underlying asset's market price rallies above the short call's strike price, producing a loss. However, the strategy limits the trader's losses to only the strike price of the call purchased.