Bear call spreads, or bear call credit spreads, are options strategies employed by options traders who expect the underlying assets price to decline in the future. So, it’s a bearish approach because the expectation is about a decrease in the price for underlying assets.
Further, it’s a credit spread because the net premium received is higher on entering the position.
Detailed concept
The bear call spread’s position is entered with the following set of options exchange.
- Purchasing call options with the specific strike price.
- Selling call options at a lower strike price. However, the date of expirations should be the same in sales and purchases of the options.
The difference in strike price arises for being long and short in the expectation of the underlying asset’s price movement. The maximum profit on implementation of such strategy is limited to the credit received while initiating options position.
Further, this strategy is also known as the short call spread. And this strategy for investment is known as the limited risk and reward strategy for the investors.
The setting of options to open the position
A bear call spread is formed by purchasing and selling call options with the same expiration date but different strike prices. The extent of a profit and loss is determined by selling and purchasing the options by strike prices. With this strategy, traders can limit their losses or realize reduced profits, making bear call spreads a limited-risk and limited-reward strategy.
The concept can be explained like you have a short call that comes with a lower strike price is used in conjunction with another long call with a higher strike price to create a bear call spread.
The short call is when traders bet/expect the price of an underlying security to fall in the future. So, it’s bearish. On the other hand, the long call is when traders expect that the price of the underlying security will rise. So, it’s bullish.
To open a bear call spread, the trader needs to write the short call option with a low strike price. On the other hand, a trader needs to buy the same number of options with a longer call and higher strike price.
Since trader’s expectation is a decrease of price in bear call spread. So, if the underlying asset’s price decreases in line with his expectation, the traders will profit because his net bet was for a decrease of the price and price has decreased. So, the buyer of the call options is not expected to exercise his right because the strike price is higher. Hence, the premium received will be profit. Although, the premium paid for the purchase of call options will be forgone. However, it’s low in amount.
So, depending on whether the stock price falls or time erodes, or both, the trader will profit from a net credit or net amount received. The potential profit is limited to the net premium received net of commission paid.
Maximum profit
To realize a profit, the net premium received is subtracted from commissions. The maximum profit is generated from the strategy when the price of an underlying asset falls below the lower strike price (short call).
So, the return generating ability of the strategy is maximum when bearish changes occur in the price of an underlying asset.
Maximum loss
The maximum loss for any investment equals the difference after the strike prices. Then you subtract the credit received and add commission paid. Further, the maximum loss is realized when the underlying asset price is above the strike price for a long call. This strategy works best for the bearish trader. However, the price of underlying assets has increased. So, it’s a loss for the trader.
Breakeven for a bear call spread
The breakeven is achieved when the price of an underlying asset equals the strike price of a short call (lower strike price) plus the net premium received. It can be given in the following formula.
Breakeven = short call strike price + net premium received on position
Given equation sets off the profit and loss as given point mathematically adjusts the premiums paid and received in terms of underlying assets’ price fluctuations.
Further, volatility in terms of profit and loss can impact the profit/loss. However, lower prices are valuable for the bear call spread.
Advantages of the bear call spread
Bear call spreads have the advantage of reducing the net risk of the trade. By buying the call option at a higher strike price, you decrease the risk associated with selling the call option at a lower strike price.
This type of trade carries significantly fewer risks than shorting, as the maximum loss is determined by how much is received for initiating the trade. Further, traders can use bear call spreads if they believe the underlying stock or security will fall a certain amount between the trade date and the expiration date. A trader can still claim that additional profit if the underlying stock falls by a more incredible amount. However, maximum profit is limited to the net credit spread. Traders are drawn to it because of the risk/reward trade-off.
Disadvantages of the bear call spread
Bear call spread may have the following disadvantages.
- If the market price of an underlying asset moves up as opposed to the bearish expectation of the trader, the potential of the loss is higher than profit. So, it does not seem to be a suitable approach.
- The strategy works better if there is volatility in the price of an underlying asset. So, it can be risky to opt for such options.
Example of Bear Call Spread
Mr. Johann expects the price of an underlying security to decrease. So, he wants to enter the options position since he is bearish and enters the following position for the options for underlying security currently trading at $45.
- Writes/sells a call option at a strike price of $30 and a premium of $2.5/share. (100 options)
- Buys call option at strike price of $40 and premium of $0.5/share. (100 options)
It can be seen that long and short strike prices are below the underlying security’s current price. It means a trader has been bearish.
Premium received = $250
Premium paid = $50
Net credit = $200
Maximum profit on position = $250-$50 =$200
Maximum loss on position = Difference of strike prices – net credit spread
Maximum loss on position = $1,000-$200
Maximum loss on position = $800
So, if the market moves in line with the expectation of Mr. Johann and the price of an underlying asset decreases to 30, which is a lower strike price, the buyer of the call options is not expected to exercise his/her right. Hence, the premium received to $250 is a complete profit for Mr. Johann. However, since the price of the underlying asset is decreased. Hence, Mr. Johann will forego his premium amounting to $50.
So, if we deduct $50 from $250, profit amounts to $200, which is the maximum possible. Any further decrease in the price of an underlying asset will not be beneficial for Mr. Johann because the strike price is locked.
On the other hand, if expectations of Mr. Johann go wrong and the price of underlying value hits a higher strike price of $40. It means the buyer of the options will exercise his/her rights, and Mr. Johann has to face the maximum loss amounting to $800 on the position.
Conclusion
Bear call options are the strategy that options traders use when expecting the price of the underlying asset to decrease before expiration. The best part of this strategy is that it limits the loss of the position. For instance, the loss is limited to the strike prices of higher and lower strike prices.
However, if the market moves in expectation of the bearish trader and price decrease, the buyer of the call options does not exercise their right. Hence, the premium received is income for the trader, and the premium paid on buying options is deducted. The net result is the net credit spread.
Frequently asked questions
When should bear call spread be exercised?
The bear call spread should be exercised when the market is expected to be bearish or mild bearish. The maximum profit with this strategy will be achieved when the price of the underlying asset moves to a lower strike price.
How does the bear call spread works?
The bear call spread works best when the underlying asset’s market price moves toward the strike price of the short call option. It’s because the buyer of the long call option does not exercise their right due to the lower price of an underlying asset. Hence, the premium received is a profit of the trader. However, the premium paid on the purchase of the option is forgone as the trader does not exercise their right due to lower underlying prices.
Why is bearish credit spread so-called?
Any spread is credit spread when the net premium received is higher than the premium paid on entering the position. Further, a given strategy is used when the trader expects the price of an underlying asset to decrease. Hence, it’s called bearish credit spread.
What’s the risk of dealing in options? Dealing with options is risky by default. It’s because all the premium paid is a loss if the price of the underlying asset does not move in line with speculation as there is no cover. However, well-known strategies like bear call spread and bull put spread cover the loss.
