Advanced Strategies for Options - Bear Call Spread

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Advanced Strategies for Options - Bear Call Spread

Like a bull spread, the bear spread is a vertical spread, that is, the investor is spreading strike price levels. Bear spreads achieve their maximum profit when the underlying stock falls in price. Also like the bull spread a bear spread has limited profit and loss potential. However, unlike the bull spread bear spreads are always established for a credit since the investor is selling a call with a lower strike price and buying a call with a higher strike price. The call with the lower strike price always trades at a higher price.

Why would an investor establish a bear spread? Because bear spreads offer limited risk they are commonly used by investors who are bearish but do not want to assume the unlimited liability associated with short sales.

Consider this example; Cisco Systems (CSCO) common stock is trading at $100 per share. Maria believes CSCO shares will fall in price but she is uncomfortable establishing an outright short sale. She decides to establish a bear spread by selling one contract of the CSCO December 100 call for $5 and buying one contract CSCO December 105 call for $1.50.

In this case Maria receives a net credit of $3.50 per contract or $350. The best case scenario would be for CSCO shares to decline below $100. If that were to occur Maria would keep the entire premium but let’s examine what happens if CSCO rises in price.

Cisco Systems Share Price at Expiration	Profit for December 100 calls	Profit for December 105 calls	Total Profit
100	$500	($150)	$350
102	$300	($150)	$150
103.50	$150	($150)	$0
105	$0	($150)	($150)
106.50	($150)	$0	($150)
108	($300)	$150	($150)
109.50	($450)	$300	($150)

As we can see if the spread expands in price Maria begins to lose money. Her loss is limited to $150, the difference between the strike prices less the credit received for the bear spread. Her potential profit is also limited. Maria achieves her maximum profit if CSCO shares decline to $100 or lower. In this case she keeps the entire premium from the 100 call and her long 105 call expires worthless. Maria’s break-even point occurs if CSCO rallies to $103.50. In this case Maria gains $150 on the short 100 calls and loses $150 on the long 105 calls.

Summary

1. Bear spreads are a bearish strategy always established for a credit.

2. The break-even point of a bear spread is equal to the lower strike price plus the amount of the credit received.

3. The maximum profit is limited to the net credit received.

4. The maximum risk is the difference between the strike prices less the net credit received.

5. In some cases a bear spread using calls may require a small margin requirement because the short call is not “covered” by a long call with a strike price equal to or lower.

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