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Options trading has many advantages, including the ability to profit in any market environment. In fact, there are several strategies for each type of market, which allow a trader to choose the most profitable. Unlike trading stock, options have various factors that determine their price. As a result, we need to understand these factors so that we do not choose the wrong strategy.

When we expect a stock to remain flat or possibly move lower, we can use a vertical spread strategy known as a bear call spread. The name explains the strategy quite well, in that we are using calls and the strategy is bearish in nature. A bear call spread is made up of two options using different strikes, but the same expiration. The lower priced option is sold and the higher strike option is purchased, resulting in a net credit.

When we sell the lower strike, we take in more premium than we pay to buy a higher strike call. Many traders might ask why we don’t just sell the call alone, rather than spending money on a higher strike. The reason is risk, which is something we want to limit. If we sell a call, we are at risk as the stock moves higher and the risk is unlimited. By buying a higher strike call, our risk is limited to a move to the highest strike. This is because if the stock moves above the highest strike, we can use this call to cover the short call.

The best way to understand this concept is to use an example. Suppose XYZ stock is trading at $49 and we feel that resistance is strong at $50. This being the case, we might want to enter a bear call spread. We might be able to sell a front month 50 call for $2.00 and buy the 55 call for $0.50. This means our net credit per spread is $1.50, which would become a profit as long as XYZ shares close at or below $50 at expiration. Below is a description of this trade and the key points to understand.

Bear Call Spread
Max Profit – Credit received
Max Risk – Difference between strikes less credit received
Breakeven – Lower strike plus credit received

For the example above, this is how these factors would compute:

XYZ 50-55 Bear Call Spread
Max Profit - (2.00 – 0.50) = 1.50
Max Risk – (55 – 50) – 1.50 = 3.50
Breakeven – (50 + 1.50) = 51.50

Not a bad deal is it? This trade would profit as long as XYZ does not gain more than 2.50 by expiration. Therefore, we make money if the stock rises slightly, stays flat or falls. The risk is that if the stock moves against us, our loss could exceed our possible profit. However, over time we expect to be profitable at least two out of three trades and even when we aren’t profitable, we should be able to cut our losses short of the maximum loss.

Viewing a risk graph is always a smart thing to do with any trade, so let’s look at a general risk graph of the above trade on XYZ. 

Figure 1: Risk Graph of Bear Call Spread

When trading a bear call spread, we normally want to use front month options. This is because we benefit from time decay and time erosion picks up the last month of an options life. We also don’t want to give the stock time to move above resistance. Using options that are showing high implied volatility can often provide a higher credit, but the risk is often not worth the added reward. If an option has extremely high IV, this could be because there is an impending news announcement. If the stock were to spike higher, we might be unable to get out without the max loss.

Next week we will go through one method of finding bear call spread candidates. We will also choose a stock to enter a mock trade on so that we can follow its progress from week to week. We can all learn from one another, so please feel free to make comments and ask questions on my forum, where we can discuss this and other options questions.  

To read previous installments of Real-World Trading, please click here.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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