Credit/Credit Spread Strategy:
Bear Call Spread

ANALOGY/METAPHOR: Being an Insurance Company in Reverse - Insuring Shareholders Against Defined Rises in a Stock's Share Price

ACTION: The bear call spread consists of simultaneously writing 1 out of the money (OTM) call option and purchasing 1 farther out of the money (FOTM) call option for a net credit. The maximum gain is the total amount of net credit received if the share price finishes below the lower strike price. The risk of loss is equivalent to the "spread" in dollar value between the two strike prices, which would occur if the stock closed at or above the higher strike price.

DESCRIPTION: With the bear call spread, you are essentially functioning as an insurance company insuring a specific stock in another's investor's portfolio from an increase in share price. That may sound a bit odd, but not everyone desires, or profits from, a rising stock. There are three variables involved in a bear call spread: what price you're insuring the stock at (strike price); how long the coverage period is (expiration date); and how much income you collect (net premium or net credit).

Additionally, like any self-respecting insurance company, you purchase reinsurance to protect yourself in case of a catastrophic event. With the bear call spread you do this by buying a call option at a strike price higher than the strike price of the call option you initially sold to collect your premium. Since the second option is cheaper than the first option, you still walk away with a net credit and your maximum loss is the difference between the two strike prices (times 100, of course, since each contract represents 100 shares) minus the net credit you initially received.

EXAMPLE: The XYZ Zipper Company is trading at $28/share. The company is facing headwinds in that some questionable photos have surfaced on the internet involving the new CEO. You've seen the photos on the internet yourself, and you feel confident that the stock will stay below $30/share in the near term. You consult the option chains on the stock and decide to employ the bear call spread option trading strategy.

You simultaneously sell a call option at the $30 strike price with an expiration date two months out for $1/contract, and purchase a call option at the $32.50 strike price with the same expiration date for $0.50/contract. Excluding commissions, you receive a net credit of $0.50/contract, or $50 ($1 less $0.50 multiplied by 100).

The possible outcomes:

• The stock closes below $30/share. Both calls expire worthless and your profit is the full amount of your original net credit. In this example, that's $50, or a 25% return ($50 divided by the $250 initial capital required, which is calculated by the difference between the $30 and $32.50 strike prices).

• The stock closes between $30/share and $32.50/share. The $32.50 call expires worthless, but the $30 call finishes in the money (ITM). Your original net credit is reduced by the amount the $30 call is ITM. Because of the $0.50 initial net credit, you don't actually begin losing money until the stock climbs above $30.50/share.

• The stock closes above $32.50/share. You lose the maximum amount possible on this trade, in this case $200. You lose $250 on the difference between the strike prices (both options expire ITM and consist fully of intrinsic value), but because you received $50 in premium at the outset, your maximum loss is only $200.

VARIATIONS: by adding a bull put spread on the same stock with the same expiration date as your bear call spread, you turn the position into an iron condor.

OTHER: As with the bull put spread, there are two primary benefits and one potentially very serious drawback provided by the bear call spread.

The first benefit is that the bear call spread limits your potential loss to the difference between the strike prices of your short and long call option. If you were crazy and reckless enough to write naked calls (and if your online options broker was crazy and reckless enough to allow you to write naked calls), theoretically, there's no limit to how much you lose if the stock rockets higher.

The second benefit is that your capital requirements are minimal compared to how many shares and how much market capitalization you're actually controlling. Compared to a reckless and stupid naked call position where you would need to hold enough cash in your account to buy 100 shares of the underlying security in the open market if the stock ever traded above your chosen strike price, the Bear Call Spread in the example above requires only $250 in capital per spread.

The Serious Drawback

As with the bull put spread, the primary drawback here is that it invites abuse as a trader almost always over-leverages. The twin benefits described above, when aggressively exploited, can easily be turned into a lethal, self-sabotaging, wrecking machine.

Let's assume that you sold a single naked call contract with a $35 strike price. That implies you've got $3500 lying around as collateral. And that figure rises as the share price rises. But in our example above, where there's only $2.50 between strike prices, each spread position requires just $250 in collateral. For the same $3500, you could set up more than 10 times the number of contracts.

There's no advantage to limiting your losses to $250 per contract if you just end up multiplying your positions by a factor of ten (maybe you're not the kind of person who does such a thing, but from personal experience, I can attest to the fact that I am). Loading up on these kind of spreads is abusing a limited risk option trading strategy until it becomes a high risk option trading strategy.


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