What is a Bear Call Spread and How to Trade it?

In the options world, a bear call spread is a bearish options strategy constructed by selling a call option with a lower strike price (closer to at-the-money) and simultaneously buying a call option with a higher strike price. This spread is initiated for a net credit, as the premium received for selling the lower strike call will be greater than the premium paid for buying the higher strike call.

From that perspective, this spread may also be referred to as a "short call spread." This strategy aims to profit from a bearish market outlook, with both limited risk and limited profit potential.

The bear call spread is technically a form of vertical spread. Vertical spreads are options strategies that involve opening long (buying) and short (selling) positions simultaneously, with the same underlying asset and expiration but with different strike prices. With a vertical spread, both options must be of the same type - both calls or both puts.

There are four types of vertical spreads, and the bear call spread is one of them. The other three vertical spreads are the bull call spread, the bull put spread, and the bear put spread. These spreads are sometimes referred to as a long call vertical (bull call spread), a short put vertical (bull put spread), a short call vertical (bear call spread), and a long put vertical (bear put spread).

A bear call spread is constructed by selling a call option with a lower strike price (closer to at-the-money) and simultaneously buying a call option with a higher strike price, both options expiring on the same date.

This spread is initiated for a net credit, as the premium received from selling the lower strike call will be greater than the premium paid for buying the higher strike call. Similar to the bear put spread, the bear call spread offers a structured approach to capitalize on downward movement or limited upward movement in the underlying asset.

More details on the bear call spread are outlined below.

Basic Concept of Vertical Spreads

• Vertical spreads entail the simultaneous buying and selling of options of the same type (calls or puts) with identical expiration dates but differing strike prices.

• These strategies are distinguished by their vertical arrangement on an options chain.

Structure of a Bear Call Spread

• In a bear call spread, the trader sells a call option with a lower strike price and concurrently buys a call option with a higher strike price.

• Both options have the same expiration date, resulting in a net credit for the position.

Profit Potential

• The objective of a bear call spread is to profit from a bearish market outlook.

• The maximum profit is realized if the price of the underlying asset remains below the lower strike call option at expiration.

Maximum Gain

• The maximum gain for a bear call spread is the net credit received when initiating the trade.

• This is achieved if the price of the underlying asset remains below the lower strike price at expiration.

Maximum Loss

• The maximum loss for a bear call spread is the difference between the strike prices minus the net credit received.

• This occurs if the price of the underlying asset exceeds the higher strike call option at expiration.

Breakeven Point

• The breakeven point for a bear call spread is the strike price of the sold call option plus the net credit received.

• The trade will be profitable as long as the price of the underlying asset remains below this level at expiration.

In the following examples, imagine that an investor or trader is bearish on the underlying and decides to deploy a bear call spread because this trade structure tends to benefit from a bearish move or sideways move in the underlying.

The two examples outlined below help illustrate how the risk-reward profile of a bear call spread shifts when different strikes are selected for the spread.

Example 1

Initial Position

• Stock XYZ is trading at $70 per share.

• The investor expects the price of XYZ to decline or stay below a certain level.

• The investor sells 1 call option with a strike price of $70 for a premium of $4 per share.

• The investor simultaneously buys 1 call option with a strike price of $75 for a premium of $2 per share.

• The net credit is equal to $4 - $2 = $2.

Maximum Gain

• The maximum gain is the net credit received when initiating the trade.

• In this case, it is $2 per share.

• Since each contract represents 100 shares, the maximum gain per contract is $200.

Maximum Loss

• The maximum loss for a bear call spread is the difference between the strike prices minus the net credit received.

• In this case, it is $75 - $70 - $2 = $3 per share.

• Since each contract represents 100 shares, the maximum loss per contract is $300.

Preferred Outcome

• The preferred outcome is for the price of XYZ to remain below $70 at expiration, in which case the maximum profit will be realized.

Example 2

Initial Position

• Stock XYZ is trading at $70 per share.

• The investor expects the price of XYZ to decline or stay below a certain level.

• The investor sells 1 call option with a strike price of $75 for a premium of $3 per share.

• Simultaneously, the investor buys 1 call option with a strike price of $80 for a premium of $1.50 per share.

• The net credit is equal to $3 - $1.50 = $1.50.

Maximum Gain

• The maximum gain is the net credit received when initiating the trade. In this case, it is $1.50 per share.

• Since each contract represents 100 shares, the maximum gain per contract is $150.

Maximum Loss

• The maximum loss for a bear call spread is the difference between the strike prices minus the net credit received.

• In this case, it is $80 - $75 - $1.50 = $3.50 per share.

• Since each contract represents 100 shares, the maximum loss per contract is $350.

Preferred Outcome

The preferred outcome is for the price of XYZ to remain below $75 at expiration, in which case the maximum profit will be realized.

As with any options-focused trading strategy, there are pros and cons associated with the bear call spread. Some of the advantages of the bear call spread are outlined below:

• Defined Risk: One of the primary advantages of the bear call spread is that it offers limited risk. As a result of its defined-risk nature, the maximum potential loss of a bear call spread is predefined and limited to the difference between the strike prices minus the net credit received when entering the trade.

• Defined Maximum Profit: Similar to the defined-risk nature of this position, the maximum profit potential of a bear call spread is also predefined. Traders know the exact amount they can potentially gain from the trade, which is the net credit received when entering the position.

• Lower Cost Basis: Compared to selling a call option outright, a bear call spread typically requires less margin because the premium paid for buying the higher strike call option helps offset the potential losses of selling the lower strike call option. This lower cost basis can make the strategy more accessible to traders with limited capital.

• Structural Flexibility: Traders can adjust the structure of the bear call spread by selecting different strike prices and expiration dates based on their outlook and risk tolerance. This flexibility allows for customization of the strategy to suit specific market expectations and trading objectives.

As with any options-focused trading strategy, there are pros and cons associated with the bear call spread. Some of the disadvantages of the bear call spread are outlined below:

• Limited Profit Potential: One of the main drawbacks of a bear call spread is that it caps the maximum potential profit. In strongly bearish scenarios where the underlying asset's price drops significantly, traders may miss out on potential profits beyond the spread's maximum gain.

• Risk of Loss: Although bear call spreads provide a net credit upfront, there is a risk of loss if the underlying asset's price rises beyond the breakeven point. The maximum loss occurs if the price of the underlying asset exceeds the strike price of the bought call option at expiration.

• Breakeven Point: The breakeven point for a bear call spread is the strike price of the sold call option plus the net credit received. The underlying asset's price must remain below this level for the trade to be profitable. If the price exceeds the breakeven point at expiration, the position will produce a loss.

• Impact of Time Decay: Although bear call spreads mitigate some effects of time decay, they don't eliminate all of the risk. As expiration approaches, the extrinsic value of the options will decline, potentially reducing the spread's value. Traders need to consider the impact of time decay when managing their positions and timing their entry and exit points.

• Margin Requirements: Despite the limited risk, bear call spreads may require a margin deposit due to the potential maximum loss. This can tie up capital and affect overall trading flexibility, especially for smaller accounts.

The preferred outcome for a bear call spread is for the price of the underlying asset to remain below the lower strike call option (the short call) at expiration. In this scenario, both options expire out-of-the-money, and the net credit received represents the maximum gain.

On the other hand, if the price of the underlying asset rises above the higher strike call option at expiration, the position will incur the maximum loss, which is limited to the difference between the strike prices minus the net credit received when entering the trade.

The maximum profit and maximum loss are summarized below.

Maximum Profit

• The maximum profit for a bear call spread is achieved if the price of the underlying asset remains below the lower strike call option at expiration.

• The maximum profit is equal to the net credit received when entering the trade.

• In this scenario, both options expire out-of-the-money.

• Formula: Maximum Profit = Net Credit Received

Maximum Loss

• The maximum loss for a bear call spread is incurred if the price of the underlying asset rises above the higher strike call option at expiration.

• The maximum loss is capped at the difference between the strike prices minus the net credit received when entering the trade.

• Formula: Maximum Loss = Difference in Strike Prices - Net Credit Received

Both a bear call spread and a bear put spread are types of vertical spreads. The primary differences between a bear call spread and a bear put spread lie in the types of options used and the expected magnitude of movement in the underlying asset.

A bear call spread involves selling a call option with a lower strike price and simultaneously buying a call option with a higher strike price, with the expectation of benefiting from a bearish market outlook or limited upward movement in the underlying asset. Conversely, with a bear put spread, the trader buys a put option with a higher strike price and sells a put option with a lower strike price, aiming to profit from a moderately bearish market outlook.

While both strategies offer limited risk and limited profit potential, the preferred outcomes differ. For a bear call spread, the ideal scenario is for the underlying asset to remain below the lower strike call option at expiration, resulting in the maximum profit. In contrast, for a bear put spread, the desired outcome is for the underlying asset to fall below the lower strike put option at expiration, which also results in the maximum profit.

In short, the bear put spread benefits from a moderately bearish move in the underlying asset, while the bear call spread tends to benefit from limited upward movement or a sideways market. Ultimately, the choice between these strategies depends on factors such as market conditions, risk tolerance, and the trader's outlook on the underlying asset.

A bear call spread involves selling a call option with a lower strike price and simultaneously buying a call option with a higher strike price. This structure aims to generate income while managing risk, making it suitable for traders with a moderately bearish or neutral market outlook.

The bear call spread is technically a form of vertical spread. Vertical spreads are options strategies that involve opening long (buying) and short (selling) positions simultaneously, with the same underlying asset and expiration, but with different strike prices. With a vertical spread, both options must be of the same type - both puts or both calls.

The preferred outcome for a bear call spread is for the price of the underlying asset to remain below the lower strike call option (the short call) at expiration. In this scenario, both options expire worthless, allowing the trader to keep the net premium received. This outcome also results in the maximum profit.

On the other hand, if the price of the underlying asset rises above the higher strike call option at expiration, the position will incur the maximum loss. However, the maximum loss is limited to the difference in strike prices minus the net credit received.

Investors and traders may also want to consider the impact of volatility on a bear call spread before initiating this type of position. Generally speaking, a decrease in implied volatility tends to benefit the bear call spread. That’s because a decrease in implied volatility tends to benefit the short call option more than the long call option (due to their relative vega components), potentially benefiting the overall value of the spread before expiration. On the other hand, an increase in implied volatility may have the opposite effect.

Another consideration with vertical spreads is the impact from time decay. As the options approach their expiration date, their extrinsic value typically diminishes. This natural decay may benefit the short call more than the long call (due to their relative theta components), especially if the underlying asset's price remains stable or declines as expected. As with any options-focused position, traders need to be mindful of time decay when choosing the strikes and expiration dates for the options in the spread.