Bear call spreads are a type of vertical spreads. They contain two calls that have the same expiration, but with differing strike prices. The strike price for the short call is below that of the strike price for the long call and both are above the underlying index or equity. This means that this strategy usually generates a cash inflow or credit/premium when the trade is first opened.
The short call’s underlying purpose is generating income, while the long call works to minimize or hedge the upside risk. Profitability for this strategy is largely dependent upon how much of the starting premium revenue is withheld before the trade expires or if it’s closed out early. As its name implies, it does best when the stock/index remains below the lower strike price over the duration of the option. If the short call leg finishes out of the money (OTM) the seller keeps 100% of the premium sold.
On the downside for the bear call spread strategy, if the underlying index or stock rallies and breaks up through the short call leg, the bear call spread will begin to drawdown and show a temporary loss. In response to this scenario, there are adjustment strategies that can help keep the loss to a minimum.
What is the outlook for bear spreads?
Are you searching for a steady stock price during the lifespan of the option? Just like any other time-limited strategy, the investor’s forecast over the long-term for the underlying stock or index isn’t as critical. The bear call spread strategy is not a suitable choice for individuals who have bullish outlooks beyond the immediate future. This strategy requires a shorter-term forecast, usually 30 to 45 days, which is accurately timed to determine when an impending short-term rally is going to run out of energy so the underlying index or stock won’t hit the short call leg.
What are the maximum losses?
Maximum loss is restricted to the margin between the short and long leg of the spread minus the initial credit received. An example of your risk is if you sold an SPX 1850/1860 bear call spread for a credit of $1. Your risk here is 10 points (1850-1860 = 10 points) minus the $1 credit received, giving you 9 points of risks. Essentially you are risking 9 to make 1. If the market were to settle above 1860 upon option’s expiration you would lose 9 points or 90% of your risk capital allocated to this trade. With this said, there are adjustment strategies that help us avoid these types of losses, where we can usually keep the losses to a minimum.
When are assignment risks possible?
Depending on what style of option (European or American) you are trading, this will determine your assignment risk. An American style option can be exercised at any time before expiration and is typical for most equity options and spreads. European style options can only be exercised upon expiration and if they are in the money (ITM), so there is only assignment risk upon expiration. Most index options are European style options.
Brad Reinard is interested in informing others about options trading. His experience in the industry makes him well-versed in the subject.