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Bear Call Spread

A trader uses this strategy when they believe the price of the stock will decrease in an alotted time frame. To conduct this trade you will buy one call that is “out” of the money and simultaneously sell a call that is “in” the money. Remember both options must be on the SAME underlying stock with the SAME expiration date. This trade limits our risk because we are selling an “in” the money call and therefore limits our potential profit. I will explain in more detail in a moment.

1. When you buy the “out” of the money call you are required to pay the premium upfront.
2. When you sell the “in” the money call you will receive a premium upfront.
3. This combination results in you receiving your maximum profit upfront.

This strategy will require you to enter the trade on a credit. In short you will receive money at the beginning of the trade, but remember this is because we sold an “in” the money call and does not guarantee you will be profitable on the trade.

Downside Risk:

Bad News: If the underlying price of the stock rises above the strike price of the call you bought “out” of the money. Then your prediction did not come to fruition and you will take a loss.

Less Bad News: The loss you will incur is only difference between the two strike prices of the options you bought and sold minus the credit you received to enter the trade. That’s it! Of course we never want to lose money but when you sell the “in” the money call you significantly reduce the loss you would have incurred.

Limited Profit Potential:

Good News: If the underlying price of the stock falls below the strike price of the call you sold “in” the money. Then your prediction and analysis was correct and you will receive a profit.

Even Better News: The profit you will receive is the full amount of the credit you received when you entered the trade.

Ok whew!! I know that was a lot and more technical than I would have liked but it was necessary. Let’s take a look at a real world example. I like showing examples because I am more of a visual learner myself!

Real World Example:

You see that MSFT is currently trading at $27.25 and you believe that by March 15, 2013 it will be trading for less than $27/share.

You decide to execute a bear call spread trade by buying the “out” of the money March $28 (strike price) Call for $43 (remember options are 100 share lots) and selling the “in” the money March $27 (strike price) Call for $87. This would bring your net credit price to $44. Not bad!

Outcomes:

Good: On March 15, 2013 the price of MSFT is trading below $27. Since the share price is below both strike prices the options will expire worthless and you will keep the initial credit of $44 as profit that you initially received to enter the trade.

So So: On March 15, 2013 the price of MSFT is trading between $27 & $28. Since the price is above our “in” the money call of $27 we will be required to sell 100 shares of MSFT at $27/share that we do not own. The “out” of the money call of $28 that we purchased will still have value so we would need to close both positions to recoup whatever value is left and avoid having to sell shares that we do not own. This is typically known as the “break even point.” Please note if you DO NOT close this position you are agreeing to sell 100 shares of MSFT for $27, it is imperative that you close this position if you do not want to sell shares you do not own.

Bad: On March 15, 2013 the price of MSFT is trading above $28. Since the difference between the strike prices are $1 you will be required to pay $100 for each contract MINUS the credit you received upon entering the trade. So in this case we would have to pay $100 – $44 for a $56 loss.

There you have it! I hope you have learned something and can add this to your trading arsenal.

Here’s to our Wealth!

Do you have experience with options spreads? If so, how were your results?