How to Trade Bear Call Spreads

  • May 21, 2019

Watch our video on how to trade bear call spreads. These are trades you make when the market is pulling back, dropping, or about to drop. Study up! Its a kangaroo market after all.

What Is a Bear Call Spread and How to Trade Them?

  1. Bear call spreads is also known as a short call or a bear call credit spread. Options traders use this strategy when they feel the price of the underlying security will go down.
  2. Sell a call, strike price A (short call).
  3. Buy a call, strike price B (long call).
  4. Receive net credit in your account.
  5. You profit if price falls, time decays, or a combo of both.

Something to keep in mind, we'll refer to all 3 names for this strategy in this artcile. This is so you're made aware they're all the same thing!

That being said, traders associate the term “bear” with falling stock prices. The term “short” or “short in the market” is a trading strategy in which you profit from falling prices in securities.

So, at the end of the day, your goal is to make money from neutral or bearish price action in the underlying stock and put time on your side.

With this in mind, a credit refers to the fact that this options strategy puts a net credit in your account

What Is a Bear Call Spread Example?

  1. In order to use this strategy, you have two steps to follow. First, you purchase a call option (or more than one) at a certain strike price (B).
  2. Second, you sell the same number of call options with the identical expiration date. However, the call option you’re selling must be at a lower strike price (A) than the call option you’re buying (B) for this strategy to be properly implemented.
  3. Typically, the stock price will be below strike A. Let's get to the good part now. The bear call spread is now in the books as an open trade, congrats!
  4. You took in a net credit in the form of money. As a result, you COULD keep the profits thanks to either a declining stock price, time erosion or a combination of the two.
  5. Your loss is limited because you are treading a spread, which fixes your max loss and max gain. It also gives you a higher chance of success (probability). You can close your trade ANY time, be it a small amount of profit, or a small loss. You don't have to keep your trade open till your expiration date. 
Bear Call Spreads

Let's explain this simply here with the diagram above:

  • Sell a call, strike price A (short call) - lets say the strike is $50.
  • Buy a call, strike price B (long call) - lets say the strike price is $55. 
  • Don't forget to pick the SAME EXPIRATION DATE!

1. Your Maximum Profits

A bear call spread makes the maximum profit when the stock price is at or below the strike price of the short call (A) at expiration. For this reason, you want the stock price to be at or below strike A at expiration, so both options expire worthlessly.

Profits received from bear call spreads are capped to the net premium received when the trade is placed minus your commission fees. Check out our trading service to learn more about options trading.

What Is a Bear Call Spread Strategy?

  • Bear call credit spreads or short call spreads look to limit risk while collecting option premiums at the same time. To put another way, they profit not only from falling stock prices but time decay.
  • For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad). Further to this, you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.

1. Real Life

Bear Calls Spreads

Sell 1 ABC 100 call at 3.30

Buy 1 ABC 105 call at (150)

Net Credit = 1.80

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2. Your Maximum Loss With Bear Call Spreads

Now let's talk about what you could lose on the trade. Luckily you're trading a spread so its capped. Therefore, your maximum loss is the difference between the two strike prices minus the net credit received, including commissions paid. Let’s break this down from the example above:

Difference between strike prices = 5 (105.00 - 100 = 5)

Net Credit = 1.80 (3.30 - 1.50 = 1.80)

Maximum Risk = 3.20 (5.00 - 1.80 - 3.20) per share less commissions

Your maximum loss happens if the stock price is at or above the strike price of the long call option at expiration. In our example, the long call option is strike price B.

Break-even Stock Price At Expiration = Strike price of short call (100.00) + net premium received (1.80) = 101.80 

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3. Advantages of Bear Call Spreads Explained

One thing to pat yourself on the back for is limiting your risk. Your bear call spread reduced your risk of losing money and fixes it to a set amount.

We at the Bullish Bears can’t emphasize enough, the importance of risk management. And by buying a call option with a higher strike price (B) you offset the risk of selling the call option with the lower strike price (A).

What’s more, a bear call spread is much less risky than shorting a stock. When you’re shorting a stock, theoretically you have unlimited risk if the stock price moves higher. However, with a short call spread, your maximum loss is only the difference between the two strike prices.

On the negative side, if the price falls further than strike price A, you miss out on any additional payoffs. In essence, that's your trade-off between risk and reward. However, in my opinion, it's the limited risk that is appealing to so many traders.

4. When Should You Trade Bear Call Spreads?

A bear call spread is your ideal play when you think the price of a stock will fall between the trade and expiration date.

Put simply, you’ll benefit using a bear call spread when the underlying price falls. In contrast, you'll lose as the price rises - no real surprise here.

In the options arena, this means your position has a “net negative delta”. We use Delta to estimate how much the option will change in price when the stock changes in price. An important point to remember is even though the stock might move up/down a dollar, the option value does not mirror that move.

What’s more, since this set up includes one long and one short call, the net delta doesn’t change that much as the stock price changes and time to expiration is unchanged.

In other words, this is a “near-zero gamma.” Gamma estimates how much the delta is going to change as the stock price changes.

5. The Risk of Early Assignment

Unfortunately, with bear call spreads there is a possibility of an early assignment. Typically short calls get assigned if the stock price is above the strike price at expiration, which makes sense.

If you didn’t know, stock options in the US can be exercised on any business day. Which means if you’re a holder of a short stock option position you have zero, yes I said zero, control over when you might have to fulfill the obligation.

The risk is real and must be taken into consideration before entering into short option positions. You don’t need to worry about the early assignment with the long call (higher strike price, B). Well, because you own the option to buy, that’s what a call is.

On the other hand, your exposure to risk (potential loss of capital) is with the option contract you sold. Someone bought it with the expectation that they will get 100 shares if they so desired.

In most cases, early assignment of stock options is tied to dividends, and you’ll see assignment on the day before the dividend date. So pay attention to ex-dividend dates and avoid trading near them if this is a concern to you.

If you find yourself in this situation, you need to deliver the shares by either buying the stock outright from the market or exercise your long call option, simple as that.

The downside here is the fees - interest, commissions and the potential for the dreaded margin call if you don’t have enough equity in your account to support your position.

Bear Spread Possibilities

6. Three Possibilities at Expiration

  1. The stock price is at or below the lower strike priceBoth the calls in the spread expire worthless. As a result, your account has no stock position created. This is the best case scenario because you get to keep the credit (premium you took in).
  2. The stock price is above the lower strike price but not above the higher strike price. Here the short call is assigned to you. You know hold 100 shares short of stock in your account. Don't worry, you can immediately cover the short position by simply buying shares if you need to or want to. 
  3. The stock price is above the higher strike price. The short call is assigned and the long call is exercised. The broker you use is familiar in executing these types of orders. End result: no stock position. But you did lose on the trade. 

7. Key Takeaways for Bear Call Spreads

  • Build them by purchasing two call options, one long and one short, with different strike prices but the same expiration date.
  • Limited-risk and limited-reward because traders can control their losses thereby limiting their rewards.
  • The strike prices determine the profits and losses
  • Run it if you feel the stock price will decline
  • Time decay is your friend
  • There's a risk of early assignment on the call option you sold

8. In Conclusion

In my opinion, the main advantage of bear call spreads is the reduction of risk because you don't own the underlying security. Your loss is capped. Therefore, you don't have to worry about losing your shirt if the stock price goes in the wrong direction.  It's a win-win all around.

So, at the end of the day, I encourage you to learn how to run option spreads. In fact, many trade them for a living. They're a great way to minimize your risk and live to trade another day and we'll show you how!

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