What are Bear Call Spreads?
A bear call spread is another example of a vertical options spread trading strategy in the options market in which the trader has an expectation of moderate bearishness on the underlying asset. He therefore will make a trade with two call options on the same asset, and with the same expiration date/time, but with different strike prices. Just like in the bull call spread, there is a short call and a long call. However, the trader purchases a call option with a certain strike price (the long call) and simultaneously sells a call option with a lower strike price (the short call).
It may also be defined as a trade where the trader sells a call option while purchasing a long call option at a higher strike price.
In essence, if we take two strike prices ($50 and $55) for a stock XY, this is what the trader does in the transaction:
Long 1 XY 50 Call
Short 1 XY 45 Call
The short call has a lower strike price, and the long call has the higher strike price. The number “1” in the trade refers to the number of options contracts purchased. 1 options contract contains 100 shares.
The profit in this trade is defined as the difference between the price paid for the long call option and that collected on the short call option.
The loss in the trade is limited to the net premium paid on the transaction.
For this example, our stock XY is trading at $50 a share. The trader wants to play the bear call spread on this stock, and buys a standard option contract worth $2 per share, or $200 per contract, with a strike price of $52.50, and sells an option contract at a strike price of $47.50, at $7 per share or $700 per contract.
In simple terms,
Long 1 XY 52.50 Call ($200)
Short 1 XY 47.50 Call ($700)
The total profit for this trade by our definition above is $700 – $200 = $500 ($5 per share)
If on expiration, the price of this stock is less than or equal to $47.50, neither option will be exercised and profit on the trade remains at $500.
If the price of the stock XY is greater than, or equal to $52.50, both options must be exercised and the trader’s profit per share is:
(original profit per share) – (stock price – $47.50) + (stock price – $52.50)
So assuming the price of the stock closed at $55.50, both options must be exercised. So the trader’s profits will be:
$5 – (55.50 – 47.50) + (55.50 – 52.50) = $5 – 8 – 3 = – $6 per share.
So this is actually not a profit but a loss.
As in other options trade types, the trader must analyse the underlying asset to determine if the bias for the stock he is trading is going to be bearish within the confines of the expiry date/time he has chosen. If the trader is able to get this right, then he will smile to the bank on payday.