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 initiation of a bear call spread results in 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 other financial instrument. (For comparison, see also "What is a Bear Put Spread?", and "What is a Bull Put Spread?")
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.
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.
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.
Advantages of a bear call spread
- 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.
- 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 sizeable 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 indexes 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 - while limited -outweigh its gains, its use should be restricted to relatively sophisticated investors and traders.
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