Bear Call Spread Explained (Simple Guide)
If you think a stock is going down in the near future and you’d like to make some money without shorting it, consider using a bear call spread strategy.
A bear call spread (or short call spread) is often better than shorting a stock because you don’t need nearly the margin requirement. That’s for two reasons:
- Options are much cheaper than stocks
- With a bear call strategy, you’re hedged with the purchase of a call option that will offset your short losses
The trick with options, of course, is that they have an expiration date. So the stock will need to drop in value before the contract expires.
A bear call option also offers limited risk and limited return. Even with that limited return, though, you can make bank when the stock moves down.
In this guide, I’ll go over the bear spread so you can determine if you’d like to use it the next time that you’re bearish on a stock.
What Is a Bear Call Spread?
A bear call spread is a type of vertical spread.
If you’re unfamiliar with a vertical spread, it’s an options strategy that involves buying and selling the same kind of options at different strike prices but with the same expiration date.
Let’s say American Express is currently trading at $108 per share. If you buy the $109 call for $2.20 and sell the $106 call for $3.90 and both calls have the same expiration date, then you’ve just created a vertical spread.
In the case of a bear call spread, you get a credit. That means you’ll get some cash in your account up front because the sale of the call at a lower strike price earns you more money than the cost of the call at the higher strike price.
In the example above, you’d get a credit of $170 ($390 – $220).
When Would You Use a Bear Call Spread?
Use a bear call spread when you think a stock is going moderately down in value in the near term.
There are a few points to keep in mind:
- The stock really needs to go down for you to make money. If the stock goes up in value, you’ll lose money.
- The stock needs to go down in value during the short term. If it goes down after the expiration date, that doesn’t do you any good. So you need a time target as well as a price target.
- The stock should drop in price only moderately. That’s because your gains are limited. If it drops significantly, you’ll still make money, but you could have made more money by just buying a put option.
Read Also: What Is The Iron Condor Options Strategy?
How Does a Bear Call Spread Work?
First things first: make sure your trading platform allows you to place multi-leg options orders. That way, you can sell one option position while simultaneously buying the other one.
Start by purchasing an out-of-the-money call option for a specific stock and expiration date. Then, sell an in-the-money call option for that same stock and expiration date.
Because the in-the-money call option has a higher on the open market than the out-of-the-money call option, you’ll get cash for the transaction right away.
That net credit, by the way, is your maximum profit. A bear call spread is an options strategy that gives you the maximum potential profit right away.
Keep in mind: you should also buy and sell the same number of options contracts. In other words, if you buy three options contracts, you should sell three options contracts.
If the underlying stock does indeed go down in value, both of the options expire worthless. That’s not a problem, though, because you’ve already earned your profit.
Real Life Example Using a Bear Call Spread?
Let’s say that Walmart is currently trading at $101 per share. You think it’s going to dip slightly in the near future, so you’d like to open a bear call spread position.
You buy the $103 call option for $2.55. That will cost you $255 because options contracts consist of 100 shares ($2.55 x 100 = $255).
Next, you sell the $100 call option for $4.44. That puts a credit in your account of $444 ($4.44 x 100).
The net credit to your account from the multi-leg order is $189 ($444 – $255). That’s your maximum profit for the trade.
If Walmart drops down to $99.50 at expiration, then both of your options expire worthless. In that case, you keep your net credit.
On the other hand, if Walmart shoots up to $105, you’re in trouble. In that case, you sell the $103 call option for $400 ($4 x 100) and buy back the short position for $700 ($7 x 100).
That means you’d be out $300 ($700 – $400). Relative to the amount of money you invested, that’s a steep loss.
Read Also: What Is The Collar Option Strategy?
What Are Similar Strategies Related to Bear Call Spread?
Here are a few strategies similar to a bear call spread:
- Bull Call Spread – Works just like a bear call spread except that you’re bullish on the stock. A key difference, though, is that it doesn’t give you a net credit right away.
- Bear Put Spread – Involves buying an in-the-money put option while simultaneously selling an out-of-the-money put option for the same stock at the same expiration date. As its name implies, it’s a strategy you’d use when you think the stock is going down in value over the short term.
- Collar Strategy – Involves selling calls against a stock that you own while simultaneously buying protective puts. It’s a limited-risk, limited-return strategy.
Bear Call Spread Compared to Other Options Strategies?
A bear call spread is one of several options strategies that offer limited risk and limited return.
Although you can make a healthy return with a bear call spread, you can’t “let your winner run” as you would with a stock or option you purchased outright. That’s because the short position will limit your profit.
Even with that limit, though, you still can make a very nice return with a bear call spread. Even better: you can earn that return in as little as 1-2 months.
Advantages & Risks of Bear Call Spread?
- Limited risk – A bear call spread limits your loss because you have both a long and a short position.
- Immediate return – You can realize your maximum profit right away. That might be a selling point for this strategy if you’re concerned about the time value of money.
- You can still lose (a lot) – Although your losses are limited, they’re not negligible. You can still lose a significant amount of money, relative to your initial investment, if the stock goes up instead of down.
- Limited return – That short position will limit your return. If you really believe a stock is going to tank, look at strategies that don’t put a cap on your profit.