Lesson Overview

Bear Call Spread

Bear call credit spreads are strategies that are designed to profit from both a one-way directional move down in the underlying stock and a drop in the underlying implied volatility. These are high probability strategies where you are a net seller of options above market price and you are looking for those options to decay and value and become worthless at expiration.

Show Video Transcript +

In this video, we’re going to be covering a bear call spread, or commonly, a credit call spread as some people like to use. It’s one of my favorite strategies. As always, we’ll get right into it here.

The market outlook for this strategy is that a trader thinks that the price of the underlying asset is going to go down moderately in the near term, and in reality, we really don't care how far it goes down. It could go down a little bit.

It could go down a lot. We just want the stock to go down in price and not go up. But it gives you a chance to earn some income with limited risk and profit from a decline in the stock’s price.

More commonly, like I said, it’s referred to as a credit spread. That's one of things that I use and it's one of my favorite strategies. How to set this up? It’s very easy to set up these bear call spreads.

They’re implemented by buying one call option of a certain strike and then selling a number of call options of a lower strike with the same price and underlying security or with the same expiration date and expiration month.

What we’re going to do here is we’re actually going to buy one out of the money call at a strike price of 40, so we’re going to buy a 40 strike call, and then we’re going to sell a more expensive in the money call at 35, creating a total credit of $200 when all said and done. Make sure that you make your spreads even.

You're going to buy an equal amount and you’re going to sell an equal amount. You’re not going to buy three and sell four. You’re going to buy one and sell one. You’re going to buy 10 and sell 10. Make sure that that's an equal amount when you're using the bear call spreads.

What's the risk of this strategy? The maximum loss is limited with the bear call spread. The worst that can happen is at expiration, for the stock to close above the higher strike. In our case, that’s going to be the 40 strike here.

Anywhere above 40, our losses are limited to just $300 on this particular strategy and we’ll go over how I calculated that later on. But the loss is limited as long as the stock closes anywhere above the higher strike.

If this happens, then you’re going to be assigned a short call that’s deep in the money and then the long call is going to get exercised and the difference between those two is going to create your maximum loss.

The profit potential for this particular strategy is limited. What we did is buy a call and sell a call, so the best that can happen is for the stock to close below both strike prices. In which case, both options expire worthless and we get to pocket the credit received when putting on the position.

This is the ideal scenario and in fact, it's the best because it saves commission as well. We don't have to buy the strategy back or exercise in the options. We just put the strategy on and we let the market take care of the rest. The options expire worthless and we keep the entire profit for ourselves.

Volatility is going to have a slight impact on this particular strategy. Since we are short one option and long another option, volatility is more or less going to offset each other to a large degree.

However, since this is a net selling strategy and we’re taking a premium, volatility overall is going to have a slightly negative impact on the strategy. Time decay is actually going to be in our favor for this strategy.

Since we are a net-seller of options with the strategy and taking in a credit on the initial outlay, then we actually want the options to decay in value and become worthless.

Each day that the stock does not go beyond our breakeven point at $37 is a great day and that creates more profits into our portfolio via time decay.

The breakeven points on this strategy are very easy to calculate. The strategy breaks even if at expiration, the stock price is above the lower strike by the amount of the initial credit received.

In this case, we would take our short strike here at 35. We would add the credit that we received. In this case, it was $2 per contract. That would be $35 plus $2 and that gets our $37 breakeven period. The stock can actually rise as high as $37 before we start to lose money at expiration.

Let’s look at an example. Let’s take a stock price that’s right at $37 right now. We would buy one call option (this is out of the money, so it’s going to be cheap at $100) and we’re going to sell one 35 call that’s in the money or at the money, depending on how the pricing is for $300 apiece.

That sale of $300 and the purchase of $100 still give us a net credit on the trade of $200 which we immediately get into our account that’s sent right to your brokers account and that's a credit in your account, real money.

The maximum loss is $300 and that is the difference between the strikes minus the credit that we received. The difference between these two strike prices is $5, we received a credit of $2 per contract or $200, so that leaves us with the difference of $300 as our max loss.

The max profit on the trade is the credit that we received and that’s $200. That’s the most we can make. We can’t make any more on the strategy.

Some tips and tricks going forward: I say always tell my coaching students and members that choosing to stay far out of the money is best for this strategy. We actually don't want to implore this strategy right near the market.

We want to get far from the market, give ourselves ample room for the market to move up, down, sideways, whatever. As long as it doesn't move beyond our strikes, then we’ll make money. Collect smaller premiums that is more consistent and learn to manage your risk better in the long run.

That has always been my strategy and it’s worked well for the last six to seven years. Hedging is very easy with these. What we can do on this is we can actually buy an additional call option above the 40 strike for short-term volatility move.

If we enter this position and we start to see the stock possibly make a breakout higher, we can go right in and buy an extra call option here which will reduce our overall exposure and potentially lead us to profiting from this strategy at the end of the day if we have a huge, huge volatility move.

Take a look at some of the other strategies that we’ve talked about in other videos, particularly some of the back spread strategies for more information on this. As always, I hope you guys enjoy watching this video and thanks again.

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