What Is Bear Call Spread

The Bear Call Spread is an intermediate strategy that can be profitable for stocks that are either rangebound or falling. The concept is to protect the downside of a Naked Call by buying a higher strike call to insure the one you sold. Both call strikes should be higher than the current stock price so as to ensure a profit even if the stock doesn’t move at all.

The higher strke call that you buy is further OTM than the lower strike call that you sell. Therefore, you receive a net credit because you buy a cheaper option than the one you sell. If the stock falls, both calls will expire worthless, and you simply retain the net credit. If the stock rises, then your breakeven is the lower strike plus the net credit you receive. Provided the stock remains below that level, then you’ll make a profit. Otherwise you could make a loss.

Sell lower strike call + Buy OTM call = Bear call spread

Maximum Risk: [Difference in strikes - net credit]

Maximum Reward:  [Net credit received]

Breakeven:  [Lower strike net credit]

With bear calls, you outlook is bearish or neutral to bearish. It’s safest to trade this strategy on a short-term basis, preferably with one month or less to expiration.

Advantages

1. Short-term income strategy not necessarily requiring any movement of the stock.

2. Capped downside protection compared to a Naked Call.

Disadvantages

1. Maximum loss is typically greater than the maximum gain, despite the capped downside.

2. High yielding trades tend to mean less protective cushion and are therefore riskier.

3. Capped upside if the stock falls.

Example

ABCD is trading at $28.00 on May 12, 2004. Sell the June 2004 $30 strike call for 1.00. Buy the June 2004 $35 strike call for 0.50.

Net Credit:  Premium sold – premium bought
                 1.00 – 0.50 = 0.50
Maximum Risk:  Difference in strikes – net credit
                 5.00 – 0.50 = 4.50   Maximum risk is greater than your net credit
Maximum Reward:  Net credit
                    0.50
Breakeven:  Lower strike + net credit
                30.00 + 0.50 = 30.50
Max ROI:  11.11%
Cushion:  $2.50 or 8.93% from breakeven

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