REAL-WORLD TRADING: Employing a Bear Call Spread (Part I)
Joel Addison, Optionetics.com
September 26, 2001
September 26, 2001
Over the last few months, we followed the movement of the Nasdaq 100 Trust (QQQ) as it related to a straddle strategy. Our mock trade used September options, which expired last Friday. Lets take a moment to review this trade.
We started the trade on July 24 when the Qs were trading at 40.15. At that time, we decided to place a straddle using the September 40 Call and Put. The net debit for this trade was $6.35, meaning that our breakeven point at expiration was 46.35 to the upside and 33.65 to the downside. With the events of September 11, the market took a major dive, which resulted in the Qs closing at 28.19. This resulted in a profit of $5.46 per straddle. The Sept 40 Call expired worthless, but the Sept 40 Put had intrinsic value of $11.81. We find the profit by subtracting the net debit from the credit, giving us the $5.46 per contract for a total profit of $546.
Okay, enough with our prior trade, lets check out a new strategy. For the next month, we are going to dissect and discuss the strategy known as a bear call spread. This strategy is a neutral to bearish strategy that takes in a credit rather than paying out a debit. I chose this strategy to use because it fits the profiles of a lot of stocks in the current market environment. Before we get into a specific trade, lets discuss the basics of a bear call spread and the kind of stock we are looking for to place this strategy on.
A bear call spread consists of selling a lower strike call and buying a higher strike call with the same expiration month. Since we are selling the closer-to-the-money call, this spread results in a net credit. During the 80s, many traders started selling naked puts to take in premium. This was a moneymaking strategy, as the market was heading straight up and rarely went down. As long as the market didnt fall, traders kept the entire premium received. Unfortunately, this strategy ended up bankrupting many traders when the crash of 1987 hit. When these naked puts moved deeply in the money, traders were hit with huge margin calls. I tell this story to explain why we use a spread strategy rather than selling options naked. Though a greater profit is achieved by not using a spread, it cannot make-up for the damage caused by a move in the wrong direction like in 1987.
The maximum profit achieved using a bear call spread is the credit received. The maximum risk is the amount of credit received, subtracted from the spread between the strikes chosen. For example, if we enter a bear call spread by selling a 50 call and buying a 55 call for a net credit of $2.00, then the maximum profit is $2.00 and the maximum risk is $3.00. This is found by taking the credit of $2 and subtracting it from the spread of five between the 50 and 55 calls. The breakeven point for a bear call spread is the credit received added on to the lower strike call. Therefore, if we receive $2 for placing the spread and we are using the 50 and 55 call spread, our breakeven point would be $52. As long as the underlying stays below 52, youre home free.
A bear call spread is often referred to as a low risk, low reward strategy. This is because the profit is finite, but the normal risk associated is also very low. Bear call spreads are best used when you feel a stock is going to move lower or will fail to move above a key resistance point. For example, if a stock has resistance at $20 and is trading at $19, you may want to place a bear call spread strategy. However, if you feel the stock is likely to fall sharply, might want to look at a more bearish strategy like a bear put spread.
The list below details criteria best suited for placing a bear call spread.
- Be slightly bearish on the stock.
- Use options that are overvalued if possible.
- Find a stock that has strong overhead resistance beneath the breakeven.
- Look at overall probability of profit, not just the risk/reward ratio.
- Normally use options that are less than 45 days out to take advantage of time erosion.
If these five points are followed, there is a high likelihood a bear call spread strategy can be extremely profitable. Next week, we will pick a stock to follow using this strategy. This way we can see first hand how the strategy works and can discuss how the movement of the market and stock affects the trade.
Joel Addison
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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