Bear Call Spread (Short Call spread)
A Bear Call Spread is an options trading strategy used when an investor believes the price of the underlying asset would probably decline moderately. There is a call spread (sell one call option at a low strike price and buy another call option at higher strike price) that has the same expiration period for both options.
The Short Call Spread Setup
Suppose you are analyzing DEF Corp, which is trading at $200 per share. You expect a soft decline and therefore decide to initiate a bear call spread by selling a call option with a strike price of $200 for $12 and buying another call option with a strike price of $210 for $7. Both options expire in three months.
Who Should Consider It
This strategy suits an investor who expects the price of his underlying stock to decline moderately or to stabilise, but not plummet. It is also suitable for investors who would like to limit further potential losses while gaining from the premium income of selling call options.
Strategy Explained
You are essentially capping your maximum loss at the difference between the two strike prices plus the net premium received by selling a call at a lower strike and buying a call at a higher strike. This strategy limits the risk involved and partially offsets the cost of the bought call through the premium received from the sold call.
Breakeven Process
The breakeven point for the bear call spread is the strike price of the lower one minus the net premium received. Therefore, in this DEF example, the net premium received is $5 per share ($12 received - $7 paid), hence the breakeven price in this case $205 per share ($200 strike price +$5 net premium).
Sweet Spot
The sweet spot for this strategy is when the stock price is at or below the lower strike price, in this case, $200 at expiration. This ensures that both call options expire worthless and the trader can keep the full premium received.
Max Profit Potential
The maximum profit of a bear call spread is the net premium received for establishing the spread. In the DEF example, the maximum profit is $5 per share.
Max Loss
This loss is limited to the difference between the two strike prices minus the net premium received. In this case, the maximum loss is $5 per share ($210 - $200 - $5).
Risk
The main risk is that the stock price ends above the breakeven at expiration, which might result in a loss up to the limit of the maximum loss. However, the risk is less as compared to selling a naked call because a higher strike call is purchased with that, providing it with protection.
Time decay, or theta, positively impacts this strategy because as expiration approaches, the value of both short and long call options generally decreases, provided the stock price does not exceed the breakeven point.
Implied Volatility
Lower implied volatility is generally better for this strategy after the position is established because it reduces the chances of the stock price hitting the higher strike price, thereby decreasing the value of the long call option more than the short call option.
Conclusion
A bear call spread is a strategy that’s designed for traders to anticipate the stock might fall modestly to moderately. It is a balanced risk-reward strategy that caps on both the potential profit and loss, allowing a trader to capture the premium decay in options. This strategy is very appealing where there are premiums due to a volatile stock.