The opposite of buying stock is shorting. The purpose of shorting is to profit if the stock declines in value. However, shorting involves significant risk, as a stock can go up indefinitely; your potential loss is technically unlimited.
If you think a stock is overpriced and might decline, the bear call spread is a strategy that can facilitate trading this expectation, while limiting the associated risk.*
Why choose the bear call spread
A bear call spread involves selling a call with a strike price at or above the current market price and purchasing another call with a higher strike price. This creates a position for which the potential loss is limited, compared with a naked short position, which has unlimited loss potential. The trade-off for limiting risk of loss is that there is a limit to your potential profits.
The bear call spread is similar to the bear put spread: Both strategies anticipate a decline in the underlying stock. The obvious dissimilarity is that calls, instead of puts, are purchased and sold, but the key difference is that a bear call spread is a credit spread. That is, you take in income at the outset of this trade. On the other hand, the bear put spread is a debit spread; you pay at the outset of the trade.
Which strategy should you implement? You may want to assess the maximum potential profit and loss of both to determine which one to use if you expect the underlying price to decline. Fortunately, both strategies allow you to identify the maximum potential profit or loss in advance.
The bear call spread's maximum profit is the net credit received, and the maximum risk is the difference in the strike prices less the net credit received at the outset. Alternatively, the bear put spread's maximum potential profit is the difference in the strike prices less the net cost of the trade, while the maximum risk is the initial cost of the spread.
You can consider the implied volatility of the options, relative to their historic volatility, to help you make a determination as to which strategy to use:
- If implied volatility is relatively high, it may be advantageous to be in a net credit position (i.e., you may get more value from selling options as opposed to buying). Thus, a bear call spread might be more attractive.
- Alternatively, if implied volatility relative to historical volatility is low, a net debit position (i.e., a bear put spread) may be more attractive.
How to construct a bear call spread
Normally, you will use the bear call spread if you are neutral or moderately bearish on a stock. Your goal is for the underlying stock to remain below the strike price of the sold call.
To construct a bear call spread, you would:
- Sell a call with a strike price at or above the current market price. The purpose of selling a call is to take in income. By selling a call with a strike price at or above the current market price, you are anticipating that the stock will not rise above the strike price, and thus it will expire worthless, so you can keep the premium.
- Buy a call with a higher strike price. The purpose of buying a higher strike call is to protect against a large increase in the price of the underlying stock. Obviously, purchasing a call reduces the net credit you take in, but it serves to protect from significant potential losses if the stock rises well above the current market price.
This spread effectively allows you to potentially profit if the stock declines in value (by keeping the income from the sold call, less the cost of the purchased call), while limiting your potential loss in the event that the stock rises in value.
If the stock does rise, the potential loss could be partially offset by the credit taken in at the outset of the trade. Also, if the stock rises above the strike price of the purchased call, losses on the sold call will be offset by gains on the purchased call, assuming the stock price rises significantly.
Before initiating the trade—what to look for:
Preparation is very important when trading options. Here are some general guidelines that you may want to follow before entering into a bear call spread:
- Find a good candidate. The most important component of making a successful bear call spread trade is identifying a stock that you expect to fall in price.
- Pick a price. After you've chosen the security that you expect a decline in value, you need to decide at which strike prices to buy and sell. For example, for a stock trading at $27, you may choose to sell a 30 call and buy a 35 call. A larger spread typically increases the profit potential, but the wider difference in premiums might increase your risk exposure, as well as increase the margin requirements of the trade.
- Pick a date. Next, choose an options expiration date that matches your expectation for the stock price to fall. Remember, the further out the expiration date, the greater the premium that you will probably take in. However, a later expiration date increases the window of opportunity for the option to be exercised, and thus, the risk of early assignment and the option being exercised at a loss. Keep in mind that ex-dividend dates and earnings announcements can play a significant role in the trade.
Assessing the potential risk/reward characteristics of each of these choices is crucial when assembling the bear call spread. One way this can be accomplished is by analyzing options greeks—particularly the delta of the sold call. The delta provides an approximate probability of the contracts expiring worthless and, thus, the likelihood you will be able to keep the credit.
An example of using greeks would be a short call that has a delta of 30. This tells you the short call has a 70% probability of expiring out of the money (i.e., not being exercised). A profit/loss probability graph can be constructed easily using the P/L calculator on Fidelity.com. Below is a graph of Fidelity's profit/loss calculator showing these probabilities.
Bear call spread example
Now that you have a basic idea of how this strategy works, let's look at a hypothetical example to get a better sense of it.
Assume that in June, you believe XYZ—currently trading at $31—will fall to $30 over the next two months. You decide to initiate a bear call spread.
This could be done by selling an XYZ August 30 call (this position would be referred to as a short call) for $3 per share, resulting in the receipt of $300 ($3 × 100). At the same time, you buy an XYZ August 35 call (long call) for $1 contract, paying out $100 ($1 × 100). The maximum potential profit is the difference between the credit you receive ($300) and the debit you pay out ($100) to construct the position. Thus, the maximum profit on this position is $200 ($300 − $100), less commission and fees, which, for simplicity, we will not consider in this example.
Your total income, or credit, at the outset of this trade is $200 ($300 − $100). The goal of the strategy is for the stock to decline in value so that you get to keep the entire $200 premium.
However, if the stock price rises, your position is subject to potential losses. Recall that the maximum potential loss for a bear call spread is the difference in the strike prices (in this example, 35 − 30) times the number of shares controlled by the contract (100), less the credit received at the outset of the trade ($200). Thus, the maximum loss on this trade is $300 ([5 × 100] − 200).
Now, let's assume the price moves in several directions. If the underlying stock remains at $30 or remains lower during the life of the contract, both options expire worthless and you get to keep the $200 profit.
If the stock rose to $35 and the 30 sold call was assigned, your loss on the position would be $300. This is calculated as the share price increase ($5) times the total number of shares controlled by the one contract (100), less the net credit received for constructing the position ($200). Note that even if XYZ rose above $35, your loss would still be $300 because any additional losses on the sold call would be offset by gains on your purchased call.
Given that the underlying stock price can move in either direction during the life of the contract, it is possible to actively manage your trade to lock in profits or prevent further losses.
One way this can be done is by repurchasing the sold option in the open market to effectively lock in the position. In our hypothetical trade above, suppose in July the stock has increased to $31 a share and you believe it could continue to rise. To cap your losses on the position, you could buy to close the XYZ August 30 call, which would offset the call you sold at the outset of the trade.
With some experience, you may be able to more effectively manage this trade. So, if you are neutral or moderately bearish on a stock and would like to limit your risk exposure, consider the bear call spread.
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