Alright. Hey everyone. This is Kirk here again from Option Alpha and in this video, we’re going to walk through a bear call spread risk calculation. Again, you might also hear people call this a short call spread or a call credit spread. There’s a lot of different names that this takes on, but essentially, it’s all the same stuff. And so, I want to walk through how to exactly calculate the maximum risk on these bear call spreads because I think sometimes, people get really confused on how to calculate it and it obviously leads to a lot of people making unfortunately, dumb decisions with how they trade and how much capital they’re putting at risk.
We’re going to start with this simple payoff diagram which is here. This is the framework of the payoff diagram. And then again, a bear call spread looks like this. This is the payoff of a bear call spread. And so, you’ll notice that a bear call spread has not only defined profit potential which is up here, but on the lower side, it has defined risk. This is one of the good things about trading bear call spreads, is that getting into the position, you should know exactly how much money you can make and how much money you can lose before you actually hit the order button to submit the order. In this case, you can see that the bear call spread payoff diagram pivots at two different points, this point here and then this point here. This point up here is where you sell an option contract. This is going to be the short contract that you sell first and then down here is going to be the contract that you go long to create this spread. In this case, let’s say you sell just one contract at an 80 strike, and this is the call option that you sold at 80, and then you bought another call option at an 85 strike. You sold the 80 strike call and then you bought the 85 strike call. This is important to start off with, with the risk calculation because the first thing that we have to use or the first thing we need to understand in order to determine the risk, is we need to determine the width of the spread that we’re trading. In this case, the width of the spread is very easy to determine. It’s just simply the difference between 80 and the 85 down here which means that our spread width here is just $5 on this position. Not $8, $5. It’s just $5 on this position. That’s the width of the spread. That is the basis that we are going to use for the purposes of calculating risk. If we had never collected any premium at all, we know that the maximum spread width and therefore, the maximum starting risk that we have is simply the difference between the spread which is $5. However, we did collect a premium from selling this option spread. When you sell a bear call spread, you collect a credit, and that is what we are going to use to subtract and reduce our risk, is that credit that we received from entering into this position.
Let’s say, for example, that this particular short 80 call strike that we had sold, we sold for $3, so we collected a $3 credit just for this individual leg. The 85 strike call that we had to buy to complete this spread, we bought for $1.72. Now, what we have to do is we have to figure out the net credit between these two contracts when we entered this position. This net credit in this case is $1.28 that we collected. We sold a call option for $3, so we collected $3, but we had to use some of that money, some of those proceeds to buy the 85 strike call for $1.72. And so, now that we bought this for $1.72, you can see that the net credit that we collected was $1.28. We take our $5 width of the spread, and we subtract the $1.28 from that amount, and that actually gets us what our net risk is on this position which is just $3.72. This is the actual risk in the position. You have an opportunity to make $1.28 here. This is your profit potential, but your risk is $3.72. Notice that when you add these two numbers together and this is the way I think about it in my mind, you add those two numbers together on each side of the payoff diagram, and the combination of those gets you to your $5 spread width and that’s how you know that everything kind of balances and makes sense. If you are doing this by hand, this is the way that I suggest which is taking the spread width, subtracting the net credit that you received and that gets you your total risk on the single contract. Again, it’s just like a double check. You just always want to add the total risk that you’ve calculated back to the net credit that you received on the contracts and that should exactly equal the width of the spread that you’re trading. Naturally, this is a really easy way to calculate how much risk is inherent in a position that you’re trading, and it’s really important that you do that because you need to understand how much risk each individual contract that you’re trading as far as bear call spreads is taking from your account because that’s the number that could really hurt you if you get into a position where the stock goes against you and the trade doesn’t work out the way you thought it was going to work.
Another thing that you should do is you should always then multiply this amount by the number of contracts that you’re trading. In this case, this is just one particular spread, but let’s say that you were trading three spreads in your account. You are selling three of the 80 strike calls and then buying three of the 85 strike calls. You would then multiply this by three contracts and that would give you a total risk of $11.16 which is actually around $1,116 of risk. That is the total risk for three contracts if you were trading it. Again, it’s just really simple to go through it on an individual contract basis first. That’s the way I do it. And then you take that individual contract risk and you multiply that by the number of contracts that you’re trading, that’s gives you a good idea of how much total risk the position is carrying in your account. As always, if you guys have any questions on how to calculate bear call spreads or anything else options related, let us know in the comments and until next time, happy trading.
The transcript is not available yet. Please check back soon.