How Does Bear CALL Spread Work? | CALL Credit Spread Explained For Newbies (Part 1 of 4)

This is the first of the 4 articles, in which I will go deeper to explain the 4 vertical spreads, for a greater understanding of how to use them in different market conditions. To quickly recap these are 4 vertical spreads options strategies that I have covered previously. In this article, I will be sharing more about the Bear CALL Spread, also known as the CALL Credit Spread.

A BEAR CALL Spread is a two-legged options strategy that involves selling a call option and collecting an upfront option premium, and then simultaneously buying a second call option with the same expiration date but a higher strike price (SP).

In the previous article, I mentioned that a bearish strategy of using CALL options is to sell CALL options, and thus in this Bear CALL Spread, selling CALL is predominant, which will result in net credit received. In order to have net credit received, the premium received must be greater than the premium paid.

Link to the previous article:
Vertical Spreads Options Strategies Explained For Newbies | A Simple Way To Understand And Remember Vertical Spreads

Using the inverse relationship between CALL options premium and strike price, i.e. higher strike price = lower premium and vice-versa, the sell CALL leg will be at a lower strike price (higher premium) than the buy CALL leg (lower premium).

As such, the buy CALL will happen at a higher SP while the sell CALL will happen at a lower SP, as summarized below:

I hope this helps in your understanding and remembering of the Bear CALL Spread. This is a powerful strategy that you can use to short the market when the market is crashing or there is an obvious downward trend while eliminating the risk of unlimited loss from naked calls or direct shorting of the shares.

What Is The Max Gain, Loss & Breakeven?

The Maximum gain of a Bear CALL Spread is the premium that you receive when you open up the contract. This happens when both contracts expire OTM and become worthless.

The Maximum loss of a BEAR CALL Spread is the difference of the strike price multiplied by 100 per contract, minus the premium you receive for the contract.

Max Loss = (Difference in SP x 100) – premium received for contract

This is when both contracts expire ITM, thus you have to sell the shares at the lower price and buy the shares at the higher price.

The Breakeven Price is the lower SP + the premium price per share.

Bear CALL Spread Example

Consider hypothetically Tesla is set to roll out full self-driving (FSD) according to speculation and has recently reached a record high of $1200 in volatile trading. Legendary Tesla bear Gordon Johnson 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 Tesla’s volatility to earn premium income but is concerned about the risk of the stock surging even higher.

Therefore, Gordon initiates a bear call spread on Tesla as follows:

Sell five contracts of $1200 Tesla calls expiring in one month and trading at $17.
Buy five contracts of $1210 Tesla calls, also expiring in one month, and trading at $12.
Because each option contract represents 100 shares, Gordon’s net premium income is $2,500, or ($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
Gordon’s view proves to be correct, and Tesla is trading at $1195. In this case, the $1200 and $1210 calls are both out of the money and will expire worthless. Gordon, therefore, gets to keep the full amount of the $2,500 net premium (less 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
Tesla is trading at $1205. In this case, the $1200 call is in the money by $5 (and is trading at $5), while the $1210 call is out of the money and, therefore, worthless.

Gordon, 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. Option A is preferable since Option B 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). Because Gordon received a net credit of $2,500 upon initiation of the bear call spread, the overall return is $0. Gordon, therefore, breaks-even on the trade but is out of pocket to the extent of the commissions paid.

Scenario 3
Tesla’s FSD claims have been validated, and the stock is now trading at $1300. In this case, the $1200 call is in the money by $100, while the $1210 call is in the money by $90.

However, since Gordon has a short position on the $1200 call and a long position in the $1210 call, the net loss on his bear call spread is: [($100 – $90) x 5 x 100] = $5,000.

But since Gordon had received $2,500 upon initiation of the bear call spread, the net loss = $2,500 – $5,000 = -$2,500 (plus commissions).

How Does This Mitigate The Risk Of Single-Legged Options?

In this scenario, instead of a bear call spread, if Gordon had sold five of the $1200 calls (without buying the $1210 calls), his loss when Tesla was trading at $1300 would be: $100 x 5 x 100 = $50,000.

Gordon would have incurred a similar loss if he had sold short 500 shares of Tesla at $1200, without buying any call options for risk mitigation.

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 = $1200 + $5 = $1205.

Advantages & Disadvantages of the Bear CALL Spread

Advantages
1. 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.

2. The bear call spread takes advantage of time decay, which is a very potent factor in options strategy. Since most options either expire or go unexercised, the odds are on the side of the bear call spread originator.
3. 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.
4. Since it is a spread strategy, a bear call spread will have lower margin requirements compared with selling naked calls.

Disadvantages
1. Gains are quite limited in this options strategy, and may not be enough to justify the risk of loss if the strategy does not work out.
2. Early assignment of short call before expiration due to sharp rise in share price. 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 a long call is substantial.
3. 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.

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