Bear Call Spread, Explained
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A bear call spread is one of four basic vertical options spreads that traders put to regular use. This strategy aims to generate income in bearish or neutral markets with limited upside potential while carrying defined risks.
Traders use a bear call spread strategy to seek potential profit on a decrease in value of the option’s underlying asset. Hence, the “bear” in the strategy’s name.
As such, a trader would typically use a bear call spread when they believe the underlying asset’s value is likely to fall.
Key Points
• A bear call spread involves selling a short call with a lower strike price and buying a long call with a higher strike price, both expiring simultaneously.
• A bear call spread can generate a net premium, be profitable if the underlying asset’s value declines, and come with limited maximum profit or loss.
• The performance of the strategy is influenced by stock price changes, volatility, and time until expiration.
• The strategy is best used when anticipating a decline in the underlying asset’s value, requiring careful market analysis.
• Consider risk management, early assignment risk, and the speculative nature of options trading.
What Is a Bear Call Spread?
A bear call spread is an options trading strategy that investors may use to potentially profit from a declining (or neutral) stock price and time decay, while also limiting the risk of loss.
With this strategy, a trader creates a spread by buying and selling two call options at the same time, attached to the same underlying asset, with the same expiration date. The key difference between the two call options is their strike price.
One call option is a long call option strategy, involving purchasing a call with a higher strike price, and the other is a short call strategy (similar to shorting a stock), involving selling a call with a lower strike price than the long call.
The bear call spread strategy benefits from the stock price staying below the lower strike price of the sold call. By selling a call option at a lower strike price and buying another at a higher strike price, the investor hopes to collect a premium for the bearish short call, while limiting potential losses through the bullish long call.
How Does a Bear Call Spread Work?
A bear call spread consists of two key positions: buying a long call and selling a short call. When the trader simultaneously purchases a long call and sells a short call (with a lower strike price), it creates a credit in the trader’s account, since the long call the trader is buying is less expensive than the short call the trader is selling. As noted above, the short call generates income for the trader by providing a premium, and the long call helps limit the trader’s potential loss.
Max Profit of a Bear Call Spread
Setting up these two call positions creates a spread, and the trader benefits when the underlying asset’s value declines. The maximum potential profit is capped at the net premium received from the sale and purchase of the call options. The investor may see the max potential profit if the stock price remains below the strike price of the sold call at expiration.
However, if the stock price rises above the strike price of the sold call, the trader may incur losses. The premium from selling the call can reduce these losses, but they could still be substantial if the strike prices move significantly higher.
Max Loss of a Bear Call Spread
If the underlying asset’s value increases, the spread can result in a loss for the trader, since the buyer of the call option may then choose to exercise the option. However, the maximum potential loss is capped at the difference between the strike prices of the two options, minus the premium received. The long call option limits loss by offsetting the risk of the short call being exercised.
Example of a Bear Call Spread Strategy
As an example, a bear call spread could involve a trader selling a short call option on a stock, which expires in one month, with a strike price of $10, for a premium of $2. The trader also buys a call option with the same expiration and a strike price of $12 for a premium of $1.
By selling the short call, they’ve received a net premium of $1. Option contracts typically control 100 shares, providing a total credit of $100. The trader has two calls with the same expiration date, but two different strike prices.
Let’s say a month goes by, and the trader’s bearish instincts have proven correct. The stock’s price declines and their call options expire below the $10 strike price of the short call. They keep the net premium of $100 and walk away with a profit.
In a downside scenario, suppose the stock climbs to $13 on expiration day. The trader closes out both contracts for a net loss of $2 per share, or $200 for each set of contracts, resulting in a $200 total loss for the strategy. This is offset by the $100 received upfront, so their net loss is just $100.
Finally, let’s analyze the break-even point. Break-even occurs at the strike price of the short call, plus the net premium received. In our example, this is the $10 lower strike, plus $1 of net premium, or $11.
Factors That Impact Bear Call Spreads
Several factors influence the outcome of a bear call spread strategy. These include the underlying asset’s price movements, market volatility, and the passage of time. Price movements influence the cost of options contracts. Market volatility impacts the extrinsic value of the contracts. The passage of time determines time decay, also known as theta.
Stock Price Change
Movement in stock price can affect a bear call significantly. This strategy benefits from a neutral to bearish market trend. When stocks rise, there is a greater chance of loss. The difference in strike prices caps both the potential profit and loss, which can therefore reduce profitability. A wider gap between the strikes can result in a lower net premium, and create higher risk exposure for the trader.
Stock Price Volatility
Volatility plays a moderate role in a bear call spread’s performance. The strategy’s maximum profit and loss are mainly influenced by the strike prices and the premiums received, rather than large price swings. That said, higher volatility generally leads to higher premiums, which can increase the income generated upfront. This also comes with a higher risk of the stock price moving beyond the strike prices, which could potentially lead to losses.
Although volatility does affect the strategy, it tends to perform best in environments with moderate or low volatility. Stable market conditions can allow the stock to stay within the expected range, which may increase the likelihood of the options expiring worthless and enabling the trader to keep the full premium as profit.
Time
Time decay plays an important role in the potential profitability of bear call spreads. As expiration approaches, the time value of the short call (i.e. lower strike) erodes more rapidly than the long call (i.e. higher strike), which benefits the position. This can work in the trader’s favor so long as the stock price remains below the short call strike, potentially turning a profit as both options lose value over time.
Benefits and Risks of a Bear Call Spread
Following are some of the potential benefits and risks associated with bear call spreads that investors should consider before using this strategy.
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Pros:
• Flexibility
• Capped potential losses
• Relative simplicity
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Cons:
• Capped potential gains
• Limited potential use
• The strategy could backfire
Benefits of a Bear Call Spread
There are some advantages to bear call spreads, which is why some traders use them to attempt to manage risk and pursue potential gains.
• Flexibility: Depending on the specific calls sold and purchased, traders can see a profit under a variety of scenarios, such as when the underlying asset’s value remains the same, or when it declines.
• Capped potential losses: There’s a maximum that a trader can lose, which also means profits are also capped. These types of strategies are used not only to seek profits, but to also limit risk.
• Relative simplicity: Bear call spreads are more straightforward than other advanced options trading strategies.
Risks of a Bear Call Spread
Bear call spreads can have their disadvantages.
• Capped potential gains: Like other vertical spread strategies, potential gains are capped — in this case, at the initial net premium credited to the account.
• Limited potential use: The strategy is most effective in neutral to bearish markets, typically with moderate to low volatility.
• The strategy could backfire: The risk is that the underlying asset sees a dramatic rise in value, rather than a fall in value as the trader predicted, resulting in significant losses on the short position. This could mean that the trader would need to sell the underlying asset at the strike price of the short call, which may lead to a loss.
Bear Call Spread Considerations and Tips
There are a few other things worth keeping in mind when it comes to the bear call spread strategy.
• There’s an early assignment risk: Since options can be exercised at any time, traders with short option positions should remember that they’re putting themselves at risk of early assignment — meaning they may be required to sell the underlying asset at the lower strike price if assigned.
• The strategy can be used in variations: A bear call spread is only one of several vertical options spreads that traders can put to use. Depending on market conditions, it could be wise to use a bullish strategy instead.
• Options trading comes with risk: It’s critical to remember that options trading is speculative. There are no guarantees, and the risk of loss is real. No matter how good any trader thinks they are at predicting the market, the risk of loss is significant. It’s important for investors to calculate the risk-reward ratio before choosing their speculative tools.
The Takeaway
A bear call spread is one of many options trading strategies a trader may employ in trying to protect themselves from losses and try to benefit from gains when they foresee a moderate decline in the underlying asset. But as with all strategies, it’s not foolproof, and there is a risk that the price of the asset might rise causing the strategy to backfire.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
How do you close a bear call credit spread?
If the stock price is moving against the position, such as the stock rising and nearing the short strike price, a trader may close the position early to limit potential losses by.
On the other hand, if the stock price stays below the short strike and both options expire worthless, the trader can simply let the position run its course, keeping the premium as profit. The decision to close often depends on the stock’s movement and how much risk the trader is willing to take.
How do you set up a bear call spread?
In order to set up a bear call spread, a trader sells a call option with a lower strike price and buys a call option with a higher strike price, both with the same underlying asset and expiration date. These two positions create the spread.
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