Bear Call Spread Explained

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What is a Bull Call Spread?

Buying a call option gives you the right, but not the obligation, to buy a stock or other financial asset at the strike price before the call’s expiration. It is an efficient way to participate in a security’s potential upside if you have limited capital and want to control risk.

But what if the call premium is too high? A bull call spread is the answer. (For other types of vertical spreads, see “What is a Bull Put Spread?”)

Bull Call Spread Basics

A bull call spread is an option strategy that involves the purchase of a call option and the simultaneous sale of another option with the same expiration date but a higher strike price. It is one of the four basic types of price spreads or “vertical” spreads, which involve the concurrent purchase and sale of two puts or calls with the same expiration but different strike prices.

In a bull call spread, the premium paid for the call purchased (which constitutes the long call leg) is always more than the premium received for the call sold (the short call leg). As a result, the initiation of a bull call spread strategy involves an upfront cost – or “debit” in trading parlance – which is why it is also known as a debit call spread.

Selling or writing a call at a lower price offsets part of the cost of the purchased call. This lowers the overall cost of the position but also caps its potential profit, as shown in the example below.

Bull Call Spread Examples

Consider a hypothetical stock BBUX is trading at $37.50 and the option trader expects it to rally between $38 and $39 in one month’s time. The trader therefore buys five contracts of the $38 calls – trading at $1 – expiring in one month, and simultaneously sells five contracts of the $39 calls – trading at $0.50 – also expiring in one month.

Since each option contract represents 100 shares, the option trader’s net outlay is =

($1 x 100 x 5) – ($0.50 x 100 x 5) = $250 (Commissions are not included for the sake of simplicity but should be taken into account in real-life situations.)

Let’s consider the possible scenarios a month from now, in the final minutes of trading on the option expiration date:

Scenario 1: BBUX is trading at $39.50.

In this case, the $38 and $39 calls are both in the money, by $1.50 and $0.50 respectively.

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The trader’s gain on the spread is therefore: [($1.50 – $0.50) x 100 x 5] less [the initial outlay of $250]

Result: the trader makes a 100% return.

Scenario 2: BBUX is trading at $38.50.

In this case, the $38 call is in the money by $0.50, but the $39 call is out of the money and therefore worthless.

The trader’s return on the spread is therefore: [($0.50 – $0) x 100 x 5] less [the initial outlay of $250]

Result: the trader breaks even.

Scenario 3: BBUX is trading at $37.

In this case, the $38 and $39 calls are both out of the money, and therefore worthless.

The trader’s return on the spread is therefore: [$0] less [the initial outlay of $250] = -$250.

Result: the trader loses the amount invested in the spread.

Key Calculations

These are the key calculations associated with a bull call spread:

Maximum loss = Net Premium Outlay (i.e. premium paid for long call less premium received for short call) + Commissions paid

Maximum gain = Difference between strike prices of calls (i.e. strike price of short call less strike price of long call) – (Net Premium Outlay + Commissions paid)

The maximum loss occurs when the security trades below the strike price of the long call. Conversely, the maximum gain occurs when the security trades above the strike price of the short call.

Breakeven = Strike price of the long call + Net Premium Outlay.

In the previous example, the breakeven point is = $38 +$0.50 = $38.50.

Profiting from a Bull Call Spread

A bull call spread should be considered in the following trading situations:

  • Calls are expensive: A bull call spread makes sense if calls are expensive, as the cash inflow from the short call will defray the price of the long call.
  • Moderate upside is expected: This strategy is ideal when the trader or investor expects moderate upside, rather than huge gains. If huge gains are expected, it’s better to hold long calls only, in order to derive the maximum profit. With a bull call spread, the short call leg caps gains if the security appreciates substantially.
  • Perceived risk is limited: Since this is a debit spread, the most the investor can lose with a bull call spread is the net premium paid for the position. The tradeoff for this limited risk profile is that the potential return is capped.
  • Leverage is desired: Options are suitable when leverage is desired, and the bull call spread is no exception. For a given amount of investment capital, the trader can get more leverage with the bull call spread than by purchasing the security outright.

Advantages of a Bull Call Spread

  • Risk is limited to the net premium paid for the position. There is no risk of runaway losses unless the trader closes the long call position – leaving the short call position open – and the security subsequently rises.
  • It can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the call strike prices are not far apart, as this will have the effect of minimizing the net premium outlay while restricting gains on the trade. An aggressive trader may prefer a wider spread to maximize gains even if it means spending more on the position.
  • It has a quantifiable, measured risk-reward profile. While it can be profitable if the trader’s bullish view works out, the maximum amount that can be lost is also known at the outset.

Risks

  • The trader runs the risk of losing the entire premium paid for the call spread. This risk can be mitigated by closing the spread well before expiration, if the security is not performing as expected, in order to salvage part of the invested capital.
  • Selling a call implies you have an obligation to deliver the security if assigned, and while you could do so by exercising the long call, there may be a difference of a day or two in settling these trades, generating an assignment mismatch.
  • Profit is limited with a bull call spread so this is not the optimal strategy if big gains are expected. Even if BBUX rose to $45 by expiration in the previous example, the maximum net gain on the call spread would only be $0.50 while a trader who had only purchased the $38 calls for $1 would see them appreciate to $7.

The Bottom Line

The bull call spread is a suitable option strategy for taking a position with limited risk and moderate upside. In most cases, a trader may prefer to close the options position to take profits or mitigate losses), rather than exercising the option and then closing the position, due to the significantly higher commission.

What Is a Bear Call Spread?

A bear call spread is an option strategy that involves the sale of a call option, and the simultaneous purchase of a different call option (on the same underlying asset) with the same expiration date but a higher strike price. A bear call spread is one of the four basic types of vertical spreads. As the strike price of the call sold is lower than the strike price of the call purchased in a bear call spread, the option premium received for the call sold (i.e., the short call leg) is always more than the premium amount paid for the call purchased (i.e., the long call leg).

Since the initiation of a bear call spread results in the receipt of an upfront premium, it is also known as a credit call spread, or alternately, as a short call spread. This strategy is generally used to generate premium income based on an option trader’s bearish view of a stock, index, or another financial instrument.

Profiting from a Bear Call Spread

A bear call spread is somewhat similar to the risk-mitigation strategy of buying call options to protect a short position in a stock or index. However, since the instrument sold short in a bear call spread is a call option rather than a stock, the maximum gain is restricted to the net premium received, while in a short sale, the maximum profit is the difference between the price at which the short-sale was effected and zero (the theoretical low to which a stock can decline).

A bear call spread should, therefore, be considered in the following trading situations:

  • Modest downside is expected: This strategy is ideal when the trader or investor expects modest downside in a stock or index, rather than a big plunge. Why? Because if the expectation is for a huge decline, the trader would be better off implementing a strategy such as a short sale, buying puts, or initiating a bear put spread, where the potential gains are large and not restricted just to the premium received.
  • Volatility is high: High implied volatility translates into an increased level of premium income. So even though the short and long legs of the bear call spread offset the impact of volatility to quite an extent, the payoff for this strategy is better when volatility is high.
  • Risk mitigation is required: A bear call spread caps the theoretically unlimited loss that is possible with the naked (i.e., uncovered) short sale of a call option. Remember that selling a call imposes an obligation on the option seller to deliver the underlying security at the strike price; think of the potential loss if the underlying security soars by two or three or ten times before the call expires. Thus, while the long leg in a bear call spread reduces the net premium that can be earned by the call seller (or “writer”), its cost is justified fully by its substantial mitigation of risk.

Bear Call Spread Example

Consider hypothetical stock Skyhigh Inc. which claims to have invented a revolutionary additive for jet fuel and has recently reached a record high of $200 in volatile trading. Legendary options trader “Bob the Bear” is bearish on the stock, and although he thinks it will fall to earth at some point, he believes the stock will only drift lower initially. Bob would like to capitalize on Skyhigh’s volatility to earn some premium income but is concerned about the risk of the stock surging even higher. He, therefore, initiates a bear call spread on Skyhigh as follows:

Sell (or short) five contracts of $200 Skyhigh calls expiring in one month and trading at $17.

Buy five contracts of $210 Skyhigh calls, also expiring in one month, and trading at $12.

Since each option contract represents 100 shares, Bob’s net premium income is =

($17 x 100 x 5) – ($12 x 100 x 5) = $2,500

(To keep things simple, we exclude commissions in these examples).

Consider the possible scenarios a month from now, in the final minutes of trading on the option expiration date:

Scenario 1

Bob’s view proves to be correct, and Skyhigh is trading at $195.

In this case, the $200 and $210 calls are both out of the money and will expire worthless.

Bob, therefore, gets to keep the full amount of the $2,500 net premium (less commissions; i.e., if Bob paid $10 per option contract, a total of 10 contracts means he would have paid $100 in commissions).

A scenario where the stock trades below the strike price of the short call leg is the best possible one for a bear call spread.

Scenario 2

Skyhigh is trading at $205.

In this case, the $200 call is in the money by $5 (and is trading at $5), while the $210 call is out of the money and, therefore, worthless.

Bob, therefore, has two choices: (a) close the short call leg at $5, or (b) buy the stock in the market at $205 in order to fulfill the obligation arising from the exercise of the short call.

The former course of action is preferable since the latter course of action would incur additional commissions to buy and deliver the stock.

Closing the short call leg at $5 would entail an outlay of $2,500 (i.e., $5 x 5 contracts x 100 shares per contract). Since Bob had received a net credit of $2,500 upon initiation of the bear call spread, the overall return is $0.

Bob, therefore, breaks-even on the trade but is out of pocket to the extent of the commissions paid.

Scenario 3

Skyhigh’s jet-fuel claims have been validated, and the stock is now trading at $300.

In this case, the $200 call is in the money by $100, while the $210 call is in the money by $90.

However, since Bob has a short position on the $200 call and a long position in the $210 call, the net loss on his bear call spread is: [($100 – $90) x 5 x 100] = $5,000

But since Bob had received $2,500 upon initiation of the bear call spread, the net loss = $2,500 – $5,000

= -$2,500 (plus commissions).

How’s this for risk mitigation? In this scenario, instead of a bear call spread, if Bob had sold five of the $200 calls (without buying the $210 calls), his loss when Skyhigh was trading at $300 would be:

$100 x 5 x 100 = $50,000.

Bob would have incurred a similar loss if he had sold short 500 shares of Skyhigh at $200, without buying any call options for risk mitigation.

Bear Call Spread Calculations

To recap, these are the key calculations associated with a bear call spread:

Maximum loss = Difference between strike prices of calls (i.e., strike price of long call less strike price of short call) – Net Premium or Credit Received + Commissions paid

Maximum Gain = Net Premium or Credit Received – Commissions paid

The maximum loss occurs when the stock trades at or above the strike price of the long call. Conversely, the maximum gain occurs when the stock trades at or below the strike price of the short call.

Break-even = Strike price of the short call + Net Premium or Credit Received

In the previous example, the break-even point is = $200 + $5 = $205.

Bear Call Spread Advantages

  • The bear call spread enables premium income to be earned with a lower degree of risk, as opposed to selling or writing a “naked” call.
  • The bear call spread takes advantage of time decay, which is a very potent factor in option strategy. Since most options either expire or go unexercised, the odds are on the side of the bear call spread originator.
  • The bear spread can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the call strike prices are not very far apart, as this will reduce the maximum risk as well as the maximum potential gain of the position. An aggressive trader may prefer a wider spread to maximize gains even if it means a bigger loss should the stock surge.
  • Since it is a spread strategy, a bear call spread will have lower margin requirements as compared to selling naked calls.

Bear Call Spread Disadvantages

  • Gains are quite limited in this option strategy, and may not be enough to justify the risk of loss if the strategy does not work out.
  • There is a significant risk of assignment on the short call leg before expiration, especially if the stock rises rapidly. This may result in the trader being forced to buy the stock in the market at a price well above the strike price of the short call, resulting in a sizable loss instantly. This risk is much greater if the difference between the strike prices of the short call and long call is substantial.
  • A bear call spread works best for stocks or indices that have elevated volatility and may trade modestly lower, which means that the range of optimal conditions for this strategy is limited.

The Bottom Line

The bear call spread is a suitable option strategy for generating premium income during volatile times. However, given that this strategy’s risks outweigh its gains, its use should be restricted to relatively sophisticated investors and traders.

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