How To Trade A Bear Call Spread

bear call spread

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During a stock market crash, buy-and-hold investors suffer but falling share prices are an opportunity to reap huge rewards for another type of trader: the short seller.

A short seller takes advantage of declining prices by selling stocks at higher prices and subsequently buying them at lower prices.

But shorting stock isn’t a holy grail trading strategy.

The problem with shorting stock is when stocks rise, losses can mount quickly. As a stock soars ever higher, short sellers continually lose money without any theoretical limit. The higher a stock goes, the more the short seller loses.

So how can you bet on falling prices when you have a negative outlook on the stock market without taking on as much risk as short selling stock?

It turns out the bear call spread can generate profits when stocks fall or even stay flat and the risks are significantly lower than shorting stock.

Let’s dive in to see how to trade a bear call spread strategy.

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How To Make Money When Stocks Fall: Bear Call Spread

A bear call spread is an options strategy that pays you a fixed amount of money in exchange for taking on limited risk.

Your bet when you place a bear call spread trade is that the underlying stock price won’t rise above a certain point.

If you are right, you get to keep the income. If you are wrong, the most you can lose is limited to a fixed amount.

Like another popular credit spread options strategy called the bull put spread, bear calls are labeled vertical spreads or vertical options spreads.

The term vertical comes about because both options are placed in the same options expiration month but at different options strike prices.

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To begin a bear call, you would sell a lower strike price call option(s) and buy a higher strike price call option(s).

The lower strike calls pay you a fixed amount of money, which exceeds the cost of buying the higher strike calls. Therefore, the overall strategy leads to a net credit – it puts money into your pocket.

Other options strategies, like debit spreads, require you to take money out of your pocket to begin a trade. For example, bear puts and bull calls are popular debit spread trades that can profit from falling or rising share prices.

The risk in debit spreads is often lower than the risk assumed in credit spreads but the flipside is you will need more share price movement to make money with debit spreads.

On the other hand, credit spreads can make money even if the underlying share price doesn’t move at all.

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A stock simply needs to stay below a certain key level, the short call strike price, to produce a profit in a bear call spread trade.

Even if the stock rises from the time the trade is entered, the bear call strategy will still turn a profit upon expiration of the call options as long as the share price remains below the critical short call strike price threshold.

The only technical trend that works against the bear call is a strong uptrend whereby the share price eclipses the short call strike price and keeps on going ever higher.

Whereas the best case trend occurs when a stock plummets lower after the position has been entered and, if it falls far enough fast enough, the call options may lose all their value producing even faster profits.

Bear call spreads are generally placed on stocks that are meandering sideways to down and are a bet on time-decay eroding the value of the options. So, they are usually placed with less than 30 → 45 days remaining to expiration when time-decay is greatest.

What Is A Bear Call Spread?

Bear call spreads are created by:

  1. Selling a lower strike price call option
  2. Buying a higher strike price call option
TypeBuySell
CallBullishBearish
PutBearishBullish

The calls you sell at the outset of the trade are known as short calls while the calls you buy are labeled long calls.

Short calls are bearish, meaning that you make money when stocks fall while long calls are bullish and profit from higher share prices.

It may seem counterintuitive to combine short calls and long calls as part of a single trade.

Don’t they cancel each other out? Not quite!

It turns out that you make more money when share prices fall from the calls sold than you lose on the long calls bought.

When a stock falls by $1, the short call may make say $0.50 per share while the higher strike price long call loses just $0.20 per share for example, leading to a net profit overall of $0.30.

The reason for this difference is due to an options Greek, called delta, which tells you how much of an option’s value changes each time a stock changes in price by $1.

The bottom line is the short call makes more money than the long call loses when an underlying stock falls in price. And conversely, the short call loses more money than the long call makes when the share price rises – hence you want stocks to fall when placing bear call spreads.

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WHAT IS THE DELTA OF A CALL OPTION?

To understand the options Greek delta in more detail, imagine you were to place a bear call spread where the call you sell has a delta of -0.50 and the call you buy has a delta of +0.20.

When the share price falls by $1, the short call makes $0.50 and the long call loses $0.20, leading to an overall gain of $0.30.

However, if the share price were to rise, the short call would lose $0.50 and the long call would be in the black by $0.20, leading an overall loss of $0.30.

What makes the bear call spread so attractive when compared to shorting stock is the percentage gains are higher while the dollars at risk are lower.

If a stock trading at $100 per share declined to $99 per share, a short stock seller could make a $1 profit or 1%.

However a bear call spread trader could perhaps make $0.30 of profit on $4 of risk, which works out to be a 7.5% gain.

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How To Place A Bear Call Spread

To place a bear call spread, execute the following instructions with your broker.

Option TypeActionStrike PriceExpiration
Short callSell To OpenLowerSame month
Long callBuy To OpenHigherSame month

The best options trading brokers cater to bear call spread trades, so whether you trade at thinkorswim or tastyworks you will be in good hands.

TASTYWORKS SPOTLIGHT
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  • Commissions: All closing trades are commission-free
  • Account Balance Minimum: $0
  • Commissions: $5 flat rate for stocks; $1 per contract for options to open

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After placing a bear call credit spread strategy, you basically need to sit on your hands and take no action until the options expiration date, at which time both options expire worthless as long as the share price is lower than the short call strike price.

Each day the overall position may not seem to be making much progress towards earning a handsome profit but rest easy knowing that time-decay is continuously taking effect, eroding the value of both options.

And while the long call will lose value, the short call will make more money, creating an overall profit.

Don’t forget that the long call is in place to limit risk in the trade. Without it, the short calls would be described as naked calls and they have much more risk than a bear call strategy.

HOW TO START AND END A BEAR CALL OPTIONS SPREAD

To place a bear call spread, the following orders are entered:

  • Sell To Open Short Calls
  • Buy To Open Long Calls

The same number of short calls and long calls would be entered. If you placed more short calls than long calls, the additional calls would be naked.

Because the spread is credit-based, the goal is for all options to expire worthless so you can avoid commissions costs of closing the spread.

If the stock were to rise unexpectedly and you wanted to close the position, you could Buy To Close the short call and Sell To Close the long call simultaneously on any of the top options trading platforms.

>> Enter the same number of short call contracts as long call contracts. If you place more short calls than long calls, the additional calls are naked and expose you to much higher risk.

Bear Call Spread Risk Graph Example

By now you know how much you can make, at least ballpark, with a bear call spread when a stock rises or falls by $1.

But now let’s take a look at a bear call spread example in more detail.

Let’s start with a stock trading at $70 per share. For now, let’s assume you don’t think it will move higher. At worse, you expect it to move sideways but best case it would decline in price.

We’ll assume the trade is entered as follows:

  • Sell call at strike 70
  • Buy call at strike 80

The lower strike price is sold at its Bid price while the higher strike price call is purchased at its Ask price.

Short Call Bid Price = $5
Long Call Ask Price = $2

Bear Call Spread Credit = $5 – $2 = $3

If everything goes well and the stock ends up at expiration below $70 per share, you will keep $3 per share or $300 per contract.

However, if the share price were to rise to $80 or above by expiration, you would lose $7 per share or $700 per contract.

BEAR CALL RISK GRAPH

Stock PriceLong Call ProfitShort Call ProfitBear Call Profit
$50-$200$500$300
$60-$200$500$300
$63-$200$500$300
$65-$200$500$300
$70-$200$500$300
$80-$200-$500-$700
$90$800-$1500-$700
$100$1800-$2500-$700

As long as the share price upon options expiration is at $70 or below, the bear call earns its maximum profit of $3 per share or $300 per contract.

Above $70 per share, the bear call spread trade starts to become problematic. The breakeven for the trade is $73 per share, excluding commissions and fees.

The breakeven level is $70 +  $3 = $73

If the share price at expiration of the options is above $73, the bear call spread will display a loss. The most it can ever lose, no matter how high the stock would ever go, is $7 per share or $700 per contract.

On the flipside, the most the spread trade could ever make is limited to the net options premium received at the start of the trade – the difference between the short call credit and the long call debit or $300 per contract here.

The maximum profit opportunity in a bear call spread is calculated as follows:

Maximum Profit = Short Call Credit – Long Call Debit

Bear Call Spread Profit Potential = [$5 – $2] = $3

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Bear Call Spread Options Tips

TIME DECAY IS ON YOUR SIDE

To maximize the effects of time-decay, bear call spreads are best placed over short time durations.

The goal is for both options to expire worthless in order to bank the full profit opportunity.

Usually, the rule of thumb is to place bear call spreads about 4 → 6 weeks out in time.

Going out further means that the rate of time-decay would slow, which in turn would slow the profitability of the trade.

MINIMIZE BID-ASK SPREADS

The bear call spread example above used round numbers to simplify the math.

When you place a trade, you will need to calculate not only the credit received when starting the position but also how much you would lose due to bid-ask spread in case you need to close the trade.

The bid-ask spread, also known as slippage, is the difference between what you pay for an option and what you would receive if you exited right away.

The more liquid a stock is, which means the more heavily it is traded, the narrower the bid-ask spread usually.

Nevertheless, you will find spreads often widen during times of volatility so it’s worth calculating the cost before placing any real money.

If in doubt, play around with the strategy on a virtual trading platform, such as from thinkorswim, so you get comfortable with how the options values vary as time and price change.

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USE IDENTICAL CONTRACT NUMBERS

A good rule of thumb is to buy the same number of calls as you sell when entering a bear call spread for the first time.

If you purchase more calls than you sell, it will hurt your profit potential when the share price falls.

However, if you sell too many calls at the outset, you will increase the risk in the trade when the stock rises in price.

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EXPIRATION MONTHS SHOULD BE IDENTICAL

To execute a bear call spread, both call options should be placed in the same expiration month.

If you were to select calls in different months at different strike prices you would create a diagonal spread.

However, when both options are in the same month, the options strategy is labeled as a vertical spread trade.

MAXIMUM RISK

The most you can lose in the a bear call spread is the difference in call strike prices minus the credit received at the start of the trade.

If the share price jumps much higher from the get-go, right after you place the trade, the maximum risk is fixed – unlike when shorting stock or selling naked calls.

To lower the chances of suffering from such a spike in share price, avoid periods of volatility where possible. For example, some stocks have a tendency to be volatile leading up to and after quarterly earnings announcements.

When Should You Trade A Bear Call Spread?

Bear calls are ideal when share prices are moving steadily lower or even sideways.

In an ideal world, a bear call spread is placed right before a share price plummets because that will lead to fastest profits.

However, it is difficult to time the market that well and, if you expected such a sharp decline, buying puts would lead to greater profits.

So, a stock that bobbles along but mostly trends lower is a good fit for this bearish vertical spread.

The one trend that will really derail the bear call is a sharp bullish trend in the underlying stock.

If you have any inkling of such a trend in the future, it is best to stay away from bear calls.

Not only will the share price work against the position at such a time but bid-ask spreads may widen and options prices may increase due to spikes in volatility.

Best Stocks For Bear Call Spreads

BEARISH OR FLAT STOCKS

Headline stocks are often not the best candidates for bear call spreads. When Amazon, Facebook, Google, or Netflix are in sharp bullish trends, they garner lots of media attention which in turn attracts retail and professional investors.

However, when high-flying stocks take a turn lower or sentiment changes, they can be ideal bear call candidates because premiums are often high.

Slower moving “boring” stocks that are flat or trending lower are also good candidates if the reward-to-risk ratios make sense.

STOCKS WITH HIGH VOLUME

The more liquid a stock is, the lower the slippage usually. While bid-ask spread is not as big a concern with credit spreads as it is with debit spreads (which need to be closed to exit), it is still worth avoiding high bid-ask spreads, just in case you things go awry and you do need to close the trade.

AVOID VOLATILITY SPIKES

The worst case outcome for a bear call spread is a big pop in share price. And while it might seem like such a spike cannot be predicted, the reality is many big movements can be predicted ahead of time.

A pharmaceutical company due to receive an FDA adjudication would exemplify a stock in which future volatility could be anticipated.

The bottom line is bear calls are best placed on stocks moving sideways or lower and which do not have upcoming fundamental catalysts that could drive share prices much higher.

Have you traded bear call spreads? What options tips can you share to boost the chances of making money? Share your comments below.

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