Bear Call Spread

Submitted by admin on Thu, 11/25/2021 - 20:34

A bear call spread is a low-risk, low-reward strategy that includes one short and one long call option.


A vertical spread, sometimes known as a bear call spread, is a form of spread. It includes two calls that have the same expiration date but different strike prices.
The short call's strike price is lower than the long call's strike price, implying that this strategy will always yield a net cash inflow (net credit) at the start.


The fundamental goal of a short call is to produce revenue, whereas the goal of a long call is to reduce upside risk.

How much of the original premium revenue is kept before the strategy is closed out or expires determines the strategy's profitability.
The stock must remain below the lower strike price for the period of the options, as the strategy's name indicates.


Even if the maximum gain of this technique is restricted, so are the possible losses, an unexpected surge should not trigger a catastrophe.

The bear put spread might be compared to this method.
After accounting for the net cost of carrying, the profit/loss payoff profiles are identical.

Net Position of a Bear Call Spread (at expiration)

EXAMPLE


1 SPY 400 call is a short position.

1 SPY 420 call is a long position.

 

GAIN PERCENTAGE TO THE MAXIMUM


Received a net bonus


LOSS EXTREME

Net premium obtained (high strike vs. low strike).


The timing of the financial flows is the most significant variation.
The bear put spread necessitates a known initial outlay in exchange for an uncertain ultimate return, whereas the bear call spread generates a known initial cash inflow in exchange for a probable outlay later on.
Outlook


During the options' life, look for a drop in the underlying stock's price.
The investor's long-term projection for the underlying stock isn't as crucial as it is with any limited-time strategy, but this isn't a good pick for those who are pessimistic in the near future. To pinpoint the point at which a coming short-term rally would change into a negative long-term trend, a precise prognosis would be required.

Summary


A bear call spread is a low-risk, low-reward strategy that includes one short and one long call option. If the stock price remains stable or falls, this method usually pays out.


The net premium obtained at the outset is the maximum it can yield.
If the projection is incorrect and the stock rises instead, the losses will accumulate until the long call expires, at which point the losses will be capped.
Motivation


The opportunity to make money with minimal risk and/or benefit from a drop in the price of the underlying stock.

Variations

Depending on how the strike prices for the long and short positions are set, a vertical call spread can be a bullish or bearish strategy.
For the bearish counterpart, see bull call spread.

Loss Maximum

There is a cap on the amount of money you can lose.
The worst-case scenario is that the stock price is greater than the higher strike at expiry.
In such situation, the short call, which is now deep in the money, will be assigned, and the long call will be exercised. The stock will be sold at the lower strike and purchased at the higher strike if the exercise and assignment are done at the same time.
The difference between the two strikes is the maximum loss, although it is lowered by the net credit earned at the outset.

The Maximum Profit

There is a cap on the amount of money you can earn.
The stock must be below both strike prices at expiry to be profitable.
Both the short and long call options will expire worthless in this instance, and the investor will keep the credit earned when the trade was opened.
Profit/Loss


This strategy's prospective profit and loss are both small and well-defined.
The maximum profit an investor may expect from the approach is the initial net credit. If the stock is trading above the lower strike price at expiry, profits begin to decrease, and losses peak if the stock is trading above the higher strike price.
Profits from executing the long call totally balance future losses on the short call when the strike price is above the higher strike price.


The maximum earning potential and maximum risk are determined by the investor's selection of the two strike prices. The investor can enhance their first net premium income by picking a lower short call strike and/or a higher long call strike.

Breakeven


If the stock price is greater than the lower strike by the amount of the original credit earned, this approach will break even at expiration. The long call would thus expire worthless, while the intrinsic value of the short call would be equal to the net credit.


Breakeven is equal to the difference between the strike price of a short call and the amount of net credit received.

Volatility

If all else is equal, a smidgeon.
Because the technique entails selling one call and buying another with the same expiration date, the impact of volatility swings on the two contracts may be largely neutralized.


However, the stock price might fluctuate to the point that a shift in volatility affects one price more than the other.
Decay of Time


Time aids the position, but not as much as it aids a simple short call position.
The effects of time decay on the two contracts may counteract each other to a great extent because the strategy entails being short one call and long another with the same expiration.

Regardless of the theoretical influence of time erosion on the two contracts, it is reasonable to believe that the passage of time is beneficial.
This method yields net up-front premium income, which is the maximum return on investment for the investor.
Any claims against it must be filed prior to the expiration date. The moment when the investor is free of such liabilities approaches as expiry approaches.

Concerns about the assignment


Yes. While early assignment can occur at any time, it is most common when a stock is about to become ex-dividend.
Due to the delay in obtaining assignment information, utilizing the long call to cover the short call assignment will necessitate building a one-day short stock position.


Also keep in mind that if a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, traditional expectations for early execution of options on the stock may be entirely thrown off.
Risk of Expiry


Yes.
Until the Monday after expiry, the investor will not know whether or not they were allocated to the short call. This puts you in danger.
If the stock is trading close below, at, or above the short call strike, the situation is exacerbated.


Let's say the short call expires slightly in the money, and the investor buys the shares in expectation of getting assigned. If assignment is not completed, the investor will not be aware of the unanticipated net long stock position until the following Monday, and the stock will be exposed to a weekend decline.


It's also possible to make a mistake in the opposite direction.
Assume the investor does not want to be assigned this time. If assignment occurred, the investor will be short the stock on Monday, and its value may have increased over the weekend.


There are two options for preparing for Monday: close the spread early or be ready for either outcome.
In any case, it's crucial to keep an eye on the stock, particularly on the final trading day.