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Bear Call Spreads: Trading Time and Volatility
A bear call spread is an options trading strategy to apply when you anticipate the stock or index price will go down or trade sideways. It involves two call options to limit both risk and reward. One call is sold to collect a premium, and another is bought at a higher strike price to manage risk.
How bear call spreads work
To open a bear call spread, you:
Sell a Call Option
The position’s profit comes from the premium collected from the sale of this option. The short call’s value can drop with a fall in the underlying price or a decline in volatility, allowing it to be repurchased at a lower cost.
- Selling the Call exposes the trader to the risk of early assignment, which would require them to buy shares of the underlying and sell them at the strike price to meet the obligation.
- Alternatively, the trader could exercise their long call to purchase the shares at its strike price to fulfill their assignment obligations on the short call. The loss would be limited to the difference between the strikes minus the premium collected when opening the spread.
- The trade profits when the call expires or is bought to close the position at a lower price than its initial sale. While selling a strike closer to the underlying price will offer a higher premium, it also increases the likelihood of the option finishing in the money.
Buy a Higher Strike Call Option
This leg is bought simultaneously with the short call. The long call reduces the premium collected and the position’s reward but limits the short call’s risk.
Bear call spread risk/reward profile:
- Reward: The net premium collected.
- Breakeven: Short (Lower) strike plus the premium received.
- Risk: The difference between the two strikes minus the premium collected.
| Quick Reference Guide: Bear Call Spread | |
|---|---|
| Market outlook | Sideways to Moderately Bearish |
| Position net debit or credit | Credit (premium collected) |
| Margin required | The difference between the strikes, minus the premium collected |
| Number of legs | Two – one lower strike short call and one higher strike long call with same expiration date |
| Maximum profit | The premium collected |
| Profits from | The options expiring with the underlying below the short strike call, from the underlying price declining, or volatility dropping |
| Maximum loss | The difference between the strikes minus the premium collected. This occurs if the underlying price rises above the long call strike. |
| Breakeven | Short strike plus the premium received |
| Risk from | The underlying price rising to or above the strike of the long call or assignment on the short call before expiration. The use of margin is required. Review the Margin Disclosure Statement at www.TradeStation.com/DisclosureMargin |
| Options level required | Level 3 – Click here for additional information |
Choosing strikes and expirations
The short call
Choose a strike above the current stock price but not too far out of the money. A lower short strike means higher premiums are collected but also increases the risk of the option going into the money and being assigned. Traders often look for strikes above a level of resistance where they believe the price will stall before the expiration of the options.
The long call
For the long call, pick a strike price one or two levels above the short strike. A narrower spread width reduces risk but also limits potential reward, while wider spreads have greater profit potential but increased possible losses. Be sure that your account size and risk management plan allow for the maximum risk of the bear call spread selected. A stop loss may be attached to an open bear call spread to mitigate risk exposure.
Choosing expirations
Evaluating the expiration is also essential. Shorter-term options have less time value but decay faster. They are also more sensitive to price changes in the underlying, which increases risk. Many traders aim for expirations ranging from 30 to 45 days to allow sufficient time for the trade to unfold. Extending the expiration period results in more expensive long calls and increased volatility risk.
Strategy comparison
Let’s examine the trading strategies of three TradeStation clients. All three believe that DaVita Inc. (DVA) is near a resistance level of around $140, and the price will likely stall and drop as it did before toward the support near $125.
Our first trader, Julia, is using the bear call spread to attempt to profit from the downward price movement. Our next trader, Xavier, is buying a put option to trade the move. Finally, Steve is a trader who shorts stocks they think will decrease in price.
Julia is selling the 140/145 bear call spread, which has 24 days until expiration, for the natural price of 1.40.
Xavier is buying a 140 put option for the natural price of 11.20. To time the exit, they chose an option with a farther expiration. Xavier wants the underlying target price to be reached while the option still has more than 30 days until expiration, reducing the effect of time decay on the position.
Steve is shorting 100 shares of DVA stock for $135.40 per share.
| Julia Bear Call Spread | Xavier Long Put | Steve Short Stock | |
|---|---|---|---|
| Trade cost /margin | $377 $360 (Difference between strikes minus premium X 100) |
$1120 Premium X 100 shares |
$6,770 $135.40 X 100 shares at 50% Margin |
| Maximum loss | $360 | $1120 | Unlimited |
| Breakeven price | $141.40 | $128.80 | N/A |
| Maximum profit | $140 | $12,880 Strike to 0) |
$13,540 |
| Realistic profit at the target of $125 | $140 – options expired out-of-themoney | $416.28 – sold with 30 days to expiration, with underlying at $125 | $1040 – with the underlying at $125 |
| Rate of return at the target | 38.9% | 37.1% | 13.4% |
| Drawbacks/Risks | 1. Options expiring with the underlying above the short strike 2. Assignment risk on the short call 3. More commissions |
1. Higher cost 2. Option expires with the underlying above breakeven 3. Underlying price doesn’t move fast/ far enough |
1. Highest cost 2. Lowest rate of return 3. The stock price drops below purchase price |
| Features | 1. Lower cost 2. Lower max risk 3. Higher rate of return 4. Can profit with little or no price movement |
1. Unlimited potential profit 2. Simple strategy, one leg 3. One commission 4. No assignment risk |
1. No time limit/ decay 2. Can receive dividends 3. Simple strategy 4. One commission |
Julia’s bear call spread could achieve the maximum profit if the price of DVA moved down to the target, stayed sideways, or even rose slightly as long as it remained under $140 until the options expired without the short call being assigned.
Favorable conditions for a bear call spread
The bear call spread offers the possibility of profiting from a sideways to moderately bearish stock or index movement. The trader expects the calls to expire worthless, so they can potentially capture the entire net credit received when initiating the spread as profit. The bear call spread may have a lower cost and might offer lower risk than buying call options outright.
Traders may consider implementing a bear call spread when implied volatility is relatively high. In such conditions, options tend to be more expensive, which can result in a larger credit received when initiating the spread. This credit represents the maximum potential profit for the trade. The bear call spread benefits from decreasing volatility and time decay. Suppose the trader closes the position before expiration by buying back the spread. In that case, a decrease in implied volatility and the passage of time may work in their favor, potentially lowering the cost to close the position and allowing them to retain a portion of the initial credit as profit.
How to place a bear call spread trade
Select a Stock or Index
Choose Strike Prices and Expiration
Considerations
- The strike of the bought call determines the position’s risk because the difference between strikes minus the premium collected is the potential maximum loss. The premium paid for the long call will reduce the premium collected from the short call.
- The strike of the sold call should be as low as possible to collect a premium but above the price the stock or index is expected to be when the options expire. The maximum profit is the net premium collected at entry.
- Because this is a credit spread, time decay helps the position. The options in the spread can be allowed to expire if they are out of the money. To experience more significant time decay,
expirations that are less than thirty days out could be chosen. Time decay increases exponentially within the last thirty days before options expiration. - Choosing longer expirations may offer greater premiums, but they experience slower time decay and may increase the possibility of assignment on the short call. Selecting deeper out-of-the-money options will lower the chance of assignment and the premium received.
Exiting the bear call spread
Test before you trade
Access the TradeStation platform in Simulated Trading mode to acquaint yourself with strategy analysis and order entry. Utilize this environment to practice placing bear call spreads without exposing real money, allowing you to gain confidence in executing the strategy.
Conclusion
In summary, the bear call spread is a strategy that involves simultaneously selling a call option and purchasing another one with a higher strike price on the same underlying asset and expiration date. The net premium received from this transaction represents the maximum potential profit for the spread. While buying the higher strike call option reduces the potential profit, it also effectively limits the maximum risk associated with the position.
The bear call spread strategy can be a valuable tool for traders anticipating that a stock or index’s price will remain relatively stable or experience a slight decline. Compared to other bearish strategies, the bear call spread offers the advantage of profiting from a broader range of potential price outcomes while maintaining limited risk exposure.
To effectively incorporate the bear call spread into your trading arsenal, it is essential to thoroughly understand its mechanics, risk-reward profile, and suitable market conditions. As with any options strategy, practicing with small positions and gaining experience through various market scenarios is crucial for success.
By mastering the bear call spread, traders can enhance their ability to navigate bearish markets, manage risk, and achieve their financial goals. When used appropriately, this strategy can be a powerful addition to a trader’s toolkit, providing an alternative approach to capitalizing on market opportunities and optimizing risk-adjusted returns.
This content is for educational and informational purposes only. Any symbols, financial instruments, or trading strategies discussed are for demonstration purposes only and are not research or recommendations. TradeStation companies do not provide legal, tax, or investment advice.
Options trading is not suitable for all investors. Your TradeStation Securities’ account application to trade options will be considered and approved or disapproved based on all relevant factors, including your trading experience. See www.TradeStation.com/DisclosureOptions. Visit www.TradeStation.com/Pricing for full details on the costs and fees associated with options.
Margin trading involves risks, and it is important that you fully understand those risks before trading on margin. The Margin Disclosure Statement outlines many of those risks, including that you can lose more funds than you deposit in your margin account; your brokerage firm can force the sale of securities in your account; your brokerage firm can sell your securities without contacting you; and you are not entitled to an extension of time on a margin call. Review the Margin Disclosure Statement at www.TradeStation.com/DisclosureMargin.
Any examples or illustrations provided are hypothetical in nature and do not reflect results actually achieved and do not account for fees, expenses, or other important considerations. These types of examples are provided to illustrate mathematical principles and not meant to predict or project the performance of a specific investment or investment strategy. Accordingly, this information should not be relied upon when making an investment decision.
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