Bear Call Spread Explained

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Bear call spread

  • Options strategies
  • Options
  • Stocks
  • Options strategies
  • Options
  • Stocks
  • Options strategies
  • Options
  • Stocks

To profit from neutral to bearish price action in the underlying stock.

Explanation

Example of bear call spread

Sell 1 XYZ 100 call at 3.30
Buy 1 XYZ 105 call at (1.50)
Net credit = 1.80

A bear call spread consists of one short call with a lower strike price and one long call with a higher strike price. Both calls have the same underlying stock and the same expiration date. A bear call spread is established for a net credit (or net amount received) and profits from either a declining stock price or from time erosion or from both. Potential profit is limited to the net premium received less commissions and potential loss is limited if the stock price rises above the strike price of the long call.

Maximum profit

Potential profit is limited to the net premium received less commissions, and this profit is realized if the stock price is at or below the strike price of the short call (lower strike) at expiration and both calls expire worthless.

Maximum risk

The maximum risk is equal to the difference between the strike prices minus the net credit received including commissions. In the example above, the difference between the strike prices is 5.00 (105.00 – 100.00 = 5.00), and the net credit is 1.80 (3.30 – 1.50 = 1.80). The maximum risk, therefore, is 3.20 (5.00 – 1.80 = 3.20) per share less commissions. This maximum risk is realized if the stock price is at or above the strike price of the long call at expiration.

Short calls are generally assigned at expiration when the stock price is above the strike price. However, there is a possibility of early assignment. See below.

Breakeven stock price at expiration

Strike price of short call (lower strike) plus net premium received.

In this example: 100.00 + 1.80 = 101.80

Profit/Loss diagram and table: bear call spread

Sell 1 XYZ 100 call at 3.30
Buy 1 XYZ 105 call at (1.50)
Net credit = 1.80
Stock Price at Expiration Short 100 Call Profit/(Loss) at Expiration Long 105 Call Profit/(Loss) at Expiration Bear Call Spread Profit/(Loss) at Expiration
108 (4.70) +1.50 (3.20)
107 (3.70) +0.50 (3.20)
106 (2.70) (0.50) (3.20)
105 (1.70) (1.50) (3.20)
104 (0.70) (1.50) (2.20)
103 +0.30 (1.50) (1.20)
102 +1.30 (1.50) (0.20)
101 +2.30 (1.50) +0.80
100 +3.30 (1.50) +1.80
99 +3.30 (1.50) +1.80
98 +3.30 (1.50) +1.80
97 +3.30 (1.50) +1.80
96 +3.30 (1.50) +1.80

Appropriate market forecast

A bear call spread earns the maximum profit when the price of the underlying stock is below the strike price of the short call (lower strike price) at expiration. Therefore, the ideal forecast is “neutral to bearish price action.”

Strategy discussion

The bear call spreads is a strategy that “collects option premium and limits risk at the same time.” They profit from both time decay and falling stock prices. A bear call spread is the strategy of choice when the forecast is for neutral to falling prices and there is a desire to limit risk.

Impact of stock price change

A bear call spread benefits when the underlying price falls and is hurt when it rises. This means that the position has a “net negative delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bear call spread consists of one short call and one long call, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bear call spread consists of one short call and one long call, the price of a bear call spread changes very little when volatility changes and other factors remain constant. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

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Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Since a bear call spread consists of one short call and one long call, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or below the strike price of the short call (lower strike price), then the price of the bear call spread decreases (and makes money) with passing of time. This happens because the short call is closest to the money and erodes faster than the long call. However, if the stock price is “close to” or above the strike price of the long call (higher strike price), then the price of the bear call spread increases (and loses money) with passing time. This happens because the long call is now closer to the money and erodes faster than the short call. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bear call spread, because both the short call and the long call erode at approximately the same rate.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of a short stock option position have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long call (higher strike) in a bear call spread has no risk of early assignment, the short call (lower strike) does have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is above the strike price of the short call in a bear call spread (the lower strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. The entire spread can be closed, which involves buying the short call to close and selling the long call to close. Alternatively, the short call can be purchased to close and the long call open can be kept open.

If early assignment of a short call does occur, the obligation to deliver stock can be met either by buying stock in the marketplace or by exercising the long call. Note, however, that whichever method is chosen, the date of stock acquisition will be one day later than the date of the stock sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the stock position created by the option assignment.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price or above the higher strike price. If the stock price is at or below the lower strike price, then both calls in a bear call spread expire worthless and no stock position is created. If the stock price is above the lower strike price but not above the higher strike price, then the short call is assigned and a short stock position is created. If the stock price is above the higher strike price, then the short call is assigned and the long call is exercised. The result is that stock is sold at the lower strike price and purchased at the higher strike price and the result is no stock position.

Other considerations

The “bear call spread” strategy has other names. It is also known as a “short call spread” and as a “credit call spread.” The term “bear” refers to the fact that the strategy profits with bearish, or falling, stock prices. The term “short” refers to the fact that this strategy is “short the market,” which is another way of saying that it profits from falling prices. Finally, the term “credit” refers to the fact that the strategy is created for a net credit, or net amount received.

Short Call Spread

AKA Bear Call Spread, Vertical Spread

The Strategy

A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B.

A short call spread is an alternative to the short call. In addition to selling a call with strike A, you’re buying the cheaper call with strike B to limit your risk if the stock goes up. But there’s a tradeoff — buying the call also reduces the net credit received when running the strategy.

Options Guy’s Tips

One advantage of this strategy is that you want both options to expire worthless. If that happens, you won’t have to pay any commissions to get out of your position.

You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this strategy.

As a general rule of thumb, you may wish to consider running this strategy approximately 30-45 days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.

The Setup

  • Sell a call, strike price A
  • Buy a call, strike price B
  • Generally, the stock will be below strike A

NOTE: Both options have the same expiration month.

Who Should Run It

Seasoned Veterans and higher

When to Run It

You’re bearish. You may also be expecting neutral activity if strike A is out-of-the-money.

Break-even at Expiration

Strike A plus the net credit received when opening the position.

The Sweet Spot

You want the stock price to be at or below strike A at expiration, so both options expire worthless.

Maximum Potential Profit

Potential profit is limited to the net credit received when opening the position.

Maximum Potential Loss

Risk is limited to the difference between strike A and strike B, minus the net credit received.

Ally Invest Margin Requirement

Margin requirement is the difference between the strike prices.

NOTE: The net credit received when establishing the short call spread may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

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).

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points and evaluate how your strategy might change as expiration approaches, depending on the Greeks.
  • Use the Technical Analysis Tool to look for bearish indicators.
  • Use the Probability Calculator to verify that strike A is about one standard deviation out-of-the-money.

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Bear Call Spreads Screener

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About Bear Calls

The best bear call strategy is one where you think the price of the underlying stock will go down.

Using a bear call strategy, you sell call options, and buy the same number of call options at a higher strike price as protection. The calls are for the same underlying stock, expiring in the same month.

  1. You sell 1 call
  2. You buy 1 higher strike call

Bear Call, Bull Call, Bear Put and Bull Put Strategies: These pages are initially sorted by descending “Break Even Probability.”

Options information is delayed a minimum of 15 minutes, and is updated at least once every 15-minutes through-out the day. The screener displays probability calculations based on the delayed stock price at the time the strategy is updated.

Main features of the Screener include:

  • Ability to add various filters, with hundreds of different combinations.
  • Save a Screener: When you’ve defined filters that you want to use again, save the screener.
  • Load a Saved Screener: Select a previously saved set of Screener filters to view today’s results.
  • View the Results using Flipcharts: Page through charts of the symbols on the results page.
  • Download the Results: Download up to 1000 results to a .csv file. The Download will also pull all of the data fields present on the View you use. Barchart Premier Members may download up to 100 .csv files per day.
  • Send an End-of-Day Email of a Screener’s Results: Barchart Premier Members can save a screener, and opt to receive 10, 25, or 50 results via email along with an optional .csv file of the top 1000 results. Emails are sent at 4:45pm CT Monday thru Friday.
Filters

Barchart Premier subscribers can add or modify different filters on the screener to find calls on the most favorable stock options.

Reordering Filters

Once filters are added, you may drag and drop them in the SET FILTERS tab to reorder the way they appear on the RESULTS tab (when using the Filters View). Each filter you add has the “Order” icon which is used to reposition it.

So you can focus on the best options, the screener starts by removing certain options:

  • Days to Expiration (monthly expirations only) is 60 days or less.
  • Security Type is only Stocks.
  • The Options Volume for both legs must be greater than or equal to 500.
  • Open Interest for both legs must be greater than or equal to 100.
  • Moneyness for Leg 1 is between -25% to 5% (OTM and ATM)
  • Break-Even Probability is greater than 25%.
  • The Leg 2 Ask Price must be greater than 0.05
  • The stock price must be greater or equal to 1.00.
  • The option must not be an “adjusted” option (the option cannot be based on a split stock).

Note: “Restricted options” (options quotes marked with an asterisk * after the strike price, and found on an individual symbol’s options page) are automatically removed from the screener. A “restricted option” is typically created after spin-offs or mergers, and are not tradeable.

Views

The Results page contains three standard views. You may switch the view using the links at the top of the screener results table. The Main View shows the Volume and Open Interest for each option, while the Dividend & Earnings View can be used to highlight strategies with upcoming dividends and earnings. The Filter view shows you the data contained in the field(s) you’ve added to the screener.

Probability Calculation

We take the underlying stock price, the break even point (target price), the days to expiration, and the 52-week historical volatility, and then use those figures in this formula. Depending on the strategy, we use the above or below probability (i.e., the probability the price crosses the break even point).

Pabove = N(d)
Pbelow = 1 – N(d)
where
N(d)= x if d > 0
= (1-x) if d and
d = 1n(b/l) / v√t,
y = 1/(1 + 0.2316419|d|),
z = 0.3989423e – (d*d)/2,
x = 1 – z(1.330274y⁵ – 1.821256y⁴ + 1.781478y³ – 0.356538y² + 0.3193815y)
and
b = break even point
l = last price
v = 52-week historical volatility
t = days to expiration
e = 2.71828

Main View

  • Stock Symbol – the underlying equity. Clicking on the symbol will take you to the current quote page.
  • Last – the delayed stock price at the time the strategy is updated for the underlying equity.
  • Max Profit – the potential return of this strategy. Max Profit is: Leg 1 Bid (OTM Call) – Leg 2 Ask (ITM Call) [Net Premium Received]
  • Max Profit% – the maximum profit, expressed as a percent. Maximum profit is achieved when the price of the underlying stock is less than or equal to the strike price of the short call
  • Max Loss – the maximum loss that the strategy might return, which is (strike price of the long call – strike price of the short call) – net premium received. Max loss occurs when the price of the underlying stock is greater than or equal to the strike price of the long call.
  • Break Even – the price of the underlying stock at which break-even is achieved: (short call strike price + the premium received from the sale of the short call)
  • Probability – the probability the last price will be at or beyond the break even point at expiration.
  • Exp Date – the expiration date of the option

    Depending on the strategy, you will be looking to buy (long) one option, and sell (short) another. The next four columns identify the strike price and bid/ask for each long and short option:

  • Leg 1 (Buy) Strike – the price at which the underlying security can be bought if the option is exercised
  • Leg 1 Ask – the premium to purchase this option
  • Leg 2 (Sell) Strike – the price at which the underlying security can be bought if the option is exercised
  • Leg 2 Bid – the premium to sell this option
  • Dividend & Earnings View

    • Dividend – the dividend the equity pays on the Ex-Dividend Date. On the morning of the Dividend Ex-Date, the stock’s price is lowered by the amount of the dividend that was just paid.
    • Dividend Ex-Date – the first day on which the stock trades without the dividend. If you wish to receive the dividend, you must own the stock by the close of market on the day before the Dividend Ex-Date. Many times, a covered call is exercised early so the buyer can own the stock and collect the dividend. This typically happens to ITM options the day before the Dividend Ex-Date.
    • Earnings Date – The date on which a company is expected to release their next earnings report. The prices are more volatile, which tends to inflate the prices of the near-the-money strikes. During a contract period when there is an earnings report due, the earnings announcement can dramatically shift the range in which the stock has been trading.
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