While options trading is inherently risky, some strategies carry lower risk than others. This is because of the inherent hedging mechanism built into the way these strategies are built. One such options trading strategy is the bear call spread. This strategy limits both the risk and the reward, making it suitable for conservative traders who want to cap their downside even if it means limiting the profits simultaneously.
Since this options trading strategy is one of the four fundamental vertical spreads (the others being bull call, bull put and bear put spreads), it is fairly simple to set up. In this article, we explore how to build this strategy, check out its possible outcomes and attempt to understand it further.
What is the Bear Call Spread?
The bear call spread is a simple two-legged options trading strategy that attempts to create a vertical spread. Also known as the short call spread, it is best used when you expect that the price of an underlying asset may decline moderately. To set up a bear call spread trade, you need to sell a call option with a lower strike price and purchase a call option with a higher strike price. Both the options must have the same expiration date.
The combination of these two trades limits the downside risk for the trader. So, the risk of suffering unlimited losses is eliminated. In a highly volatile segment like the options market, this can be a significant advantage.
Setting up the Bear Call Spread
To construct this options trading strategy, you only need to execute two trades, as outlined below.
- Sell a Call Option (Lower Strike)
You must sell a call option with a low strike price. If the asset’s price falls by expiry as you expect it to, this option will expire worthless and you can profit from the premium received.
- Buy a Call Option (Higher Strike)
Simultaneously, you also buy a call option with a higher strike price than the short call. This trade acts as a hedge against potential upswings as the call will then expire worthless or lead to a profit, depending on how much the price rises.
Key Formulas in the Bear Call Spread
To better understand the nuances of this options trading strategy, you need to know how to compute the total cost of setting up this trade, what its maximum profit and loss potential are and where the break-even points occur. Let us delve into these details.
- Cost of the Trade
The total cost of the trade is the difference between the premium paid for the long call and the premium received for the short call.
- Maximum Gain or Profit
The maximum profit from this options trading strategy occurs when the asset price reaches or falls below the lower strike price in the trade. In that case, both the call options expire worthless, leaving you with a maximum gain equal to the net premium received.
- Maximum Risk or Loss
The maximum risk from this trade occurs if the asset price moves upward instead, and rises to reach the higher strike price or goes above this level. In that case, the maximum loss from the trade is computed as follows:
Maximum Loss = Strike Price of the Long Call — Strike Price of the Short Call — Net Premium Received
As you can see, the maximum loss is also capped, leading to a limited risk and limited reward setup. This makes the bear call spread ideal for traders who are conservative or moderate in their outlook towards risk.
- Break-Even Point
The break-even point for the bear call spread position occurs when the total outcome is neither profitable nor loss-making. The formula to compute the break-even price level for this options trading strategy is as follows:
Break-Even Point = Strike price of the Short Call + Net Premium or Credit Received
At this price level, the outcome of the bear call spread will be neutral. Let us discuss an example to better understand how these calculations translate to practical scenarios.
An Example of the Bear Call Spread Strategy
Suppose that a company’s stock is currently trading at Rs. 400. You expect that the stock will likely fall by a few points in the next few trading sessions. So, to capitalise on this price movement, you decide to implement the bear call spread strategy and execute the following trades:
- Sell a call option with a strike price of Rs. 398 for a premium of Rs. 15
- Buy a call option with a strike price of Rs. 410 by paying a premium of Rs. 4
The total cost of setting up this trade is the net premium received, which is Rs. 11. Depending on how the stock price moves at expiry, you may make a profit or a loss, as explained in the scenarios below.
- Scenario 1: Stock Price at Expiry is Below the Short Call’s Strike
Your assumption proves to be right and the stock price falls at expiry to Rs. 395. This means both the options expire worthless and the net premiums earned will be the profit from the trade — amounting to Rs. 11.
- Scenario 2: Stock Price at Expiry is Between the Two Strikes
Now, say the stock is trading at Rs. 405 on the expiry date. In this case, the short call will be profitable for the buyer, leading to the following outcome for you:
Profit/Loss:
= Premium Received — Rs. (405 — 398)
= Rs. 15 — Rs. 7
= Rs. 8
The long call option, however, will be worthless and the premium of Rs. 4 that you paid will be a loss. This leads to a total profit of Rs. 4 (i.e. 8 — 4).
- Scenario 3: Stock Price at Expiry is Above the Long Call’s Strike
Now, let’s say the stock price moves entirely in an unfavourable direction and exceeds the long call’s strike price at expiry. For instance, say it rises to Rs. 425. In this case, the short call will be profitable for the buyer, but since you sold the option, the outcome from this trade will be as follows:
Profit/Loss:
= Premium Received — Rs. (425 — 398)
= Rs. 15 — Rs. 27
= — Rs. 12 (loss)
As for the long call, it will also be profitable for you, the buyer. The outcome from this trade will computed as follows:
Profit/Loss:
= Rs. (425 — 410) — Premium Paid
= Rs. 15 — Rs. 4
= Rs. 11
The total outcome from this trade will be a loss of Re. 1 (i.e. Rs. 11 — Rs. 12).
Note: The profits and losses outlined above will be multiplied based on the number of lots purchased or sold as well as the lot size of the options concerned.
When to Use the Bear Call Spread
This options trading strategy can be a suitable choice in any of the following scenarios:
- When You Expect a Moderate Price Decline
The bear call spread is a suitable strategy when you expect an asset’s price to fall by a certain limited level over a specific period. This strategy is typically used in moderately bearish market conditions where a slight decline or stagnation in the stock price is expected.
- When You Want to Implement a Controlled Risk Strategy
The bear call spread limits both potential profit and loss. The maximum profit is realised if the stock price is at or below the lower strike price at expiry, making both options expire worthless. The maximum loss occurs if the stock price exceeds the higher strike price at expiry.
- When You Need a Profit Buffer in Slightly Bearish Markets
This strategy provides a profit buffer even if the stock price does not drop significantly. It offers a higher probability of profit with controlled risk, making it an attractive choice for cautious investors aiming to capitalise on a stable or slightly declining market.
Improve Your Options Trading Outcomes with Samco Calculators and Tools
While the bear call spread seems like a straightforward strategy, you need to analyse different aspects of the trade before entering the market. The wide range of Samco calculators designed specifically for options traders can help you with this.
You can use the fair value calculator to gauge how the value of an options contract changes when the underlying asset’s price moves. There is also a separate Samco calculator to compute the SPAN margin for trades in the derivatives segment. This can be handy if you want to account for the total cost of your options trades and assess the true potential gains from the bear call spread or any other options trading strategy. Another useful Samco calculator is the brokerage computation tool, which gives you more insights into the trading costs involved.
To access these Samco calculators and other industry-first tools like the strategy builder Options B.R.O. for free in the Samco trading app, sign up for a Samco trading account today.
