Bear Call Spread

A bear call spread refers to a vertical spread involving two calls with different rates but sharing the same expiration date.


What Is a Bear Call Spread?

A bear call spread is a vertical spread composed of two calls with different strike rates but the same expiration date. It is a low-risk and low-profit strategy. The purpose is to generate optimal revenue at minimum risk. It is designed to make a profit in bearish or neutral price action. 

Understanding Bear Call Spread

A bear call has two calls of the same expiration while having different strike rates:

  • Long Call

In a bear call spread, the long call is the call option bought as part of the spread. This option is bought at a higher strike price than the call options sold, known as the short call of the spread.

The purpose of the long call is to limit the losses from the short call if the underlying security price rises instead of falls. 

  • Short Call

In a bear call spread, the short call is the call option sold as part of the spread. This option is sold at a specific strike price, at which the underlying security can be bought or sold if the option is exercised. The investor receives a premium upon selling call options, representing the trade’s potential profit.

The purpose of the short call is to profit from a decline in the underlying security price.

Here’s How It Works:

Suppose an investor initiates a bear call spread by selling call options on XYZ Corporation’s stock with a strike price of $50 and simultaneously buying call options on XYZ stock with a strike price of $60.

If the price of XYZ stock goes below $50 within the time frame specified by the options, the short call of the spread will expire without being exercised, and the investor will keep the premium as profit.

However, if the price of XYZ stock rises above $50 but remains below $60, the short spread call will be exercised, requiring the investor to sell the stock at the strike price of $50. In this case, the long call of the spread will also be exercised, allowing the investor to buy the stock at the higher strike price of $60.

The net result is that the investor will incur a loss equal to the difference between the strike prices of the short and long calls of the spread. For example, if the price of XYZ stock is $55 when the options are exercised, the investor will incur a loss of $5 per share ($50 – $60). This loss is limited by the long call of the spread and is much smaller than the potential loss from simply selling call options without a long leg.

Overall, the long call in a bear call spread helps to limit the potential losses from the short call of the spread if the underlying security price rises instead of falls. It is a more conservative approach than simply selling call options and can help investors manage their risks more effectively.

Working on Bear Call Spread

The bear call spread works on defined principles with their advantages and disadvantages.

Maximum Loss

The maximum loss a seller can receive in a bear call spread equals the difference between the strike prices and the net credit. Maximum loss is experienced when the stock price is equal to or greater than the long call of the bear call spread.

High Strike – Low Strike – Net Credit

Maximum Gain

The net premium offered is the maximum gain or profit in a bear call spread. It is experienced when the stock price is equal to or greater than the short call at the expiration time.

Break Even

The bear call strategy is set to break even when the total stock price at the end of the expiration date is equal to the rate of the short call summed with the net premium received.

Breakeven=Short Call+Net Credit

Volatility

Since the bear call spread has short and long calls, the price fluctuation does not affect the spread much. The stock price and expiration date remain constant, and the change is distributed amongst the calls.

Example of a Bear Call Spread

Suppose an investor believes that the price of XYZ Corporation’s stock is likely to decline in the coming weeks. They decide to initiate a bear call by selling call options on XYZ stock with a strike price of $50 and an expiration date of three months from now.

The investor receives a premium for selling the call options, representing the trade’s potential profit. If the price of XYZ stock declines below $50 within the next three months, the options will expire without being exercised, and the investor will keep the premium as profit.

On the other hand, if the price of XYZ stock rises above $50 within the next three months bear call spread is applied as investors sell the stock at the strike price of $50. In this case, the investor will incur a loss equal to the difference between the strike price and the stock’s market price when the options are exercised.

Generally, a bear call is a way for investors to profit from a decline in the price of a particular security. It is a risky strategy, as there is always the potential for losses if the underlying security’s price rises instead of falls.