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THE ULTIMATE GUIDE TO
THE BEAR CALL SPREAD
4,500 word guide
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A bear call spread is a very common trade for options traders. It has a directional bias
as hinted in the name and also benefits from time decay, so it is popular with income
traders.
Contents
What Is A Bear Call Spread?
Maximum Loss
Maximum Gain
Breakeven Price
Payoff Diagram
Risk of Early Assignment
Bear Call Spread Calculator
How Volatility Impacts Bear Call Spreads
How Time Decay Impacts Bear Call Spreads
Delta
Gamma
Risks
Bear Call Spread vs Bear Put Spread
Trade Management
Short-Term vs Long-Term Bear Call Spreads
Bear Call Spread Examples
Frequently Asked Questions About Bear Call Spreads
Summary
One call option is being sold, which generates a credit for the trader. Another call
option is bought to provide protection against an adverse move.
The sold call is always closer to the stock price than the bought call.
As the name suggests, this trade does best when the stock declines after the trade is
open.
However, there can be many cases where this trade can make a profit if the stock
stays flat and even if it rises slightly.
We’ll look at lots of examples later in this post, including how to manage the trade
when it goes against you.
Bear call spreads are risk defined trades, there are no naked options here, so they can
be traded in retirement accounts such as an IRA.
Maximum Loss
The maximum loss on a bear call spread is limited.
The worst-case scenario is known in advance so there will be no surprises for the
trader If disaster strikes.
If the stock rallies and moves above the bought call the trader will be sitting on an
unrealized loss.
If this move occurs early in the trade, the loss may be less than the maximum because
of the time premium remaining in the options.
At initiation, this trade was slightly out-of-the-money with SPY trading around $255
and the spread placed at $260-$265.
The trader was expecting that SPY would stay below $260 over the course of the
trade.
Max Loss: $1,380
On the payoff diagram, we can see that halfway through the trade’s duration, if SPY
rises to 269, the maximum loss is not yet incurred.
However, if SPY stays at that level, the losses will continue to get larger heading
towards expiry, eventually suffering the full max loss.
Maximum Gain
The maximum gain on a bear call spread is also limited and it is a bit easier to
calculate.
It is simply the amount of credit, or premium, received at trade initiation.
The best-case scenario is that the stock stays below the sold call for the duration of
the trade and finishes below on expiry day.
Both options expire worthless and the options are removed from the traders account
and he keeps the premium.
In the above example, $1,120 in premium was received at trade initiation and this is the
maximum gain that can be achieved from the trade.
Like the maximum loss, the maximum gain can only be achieved at expiry.
In our example, if SPY drops to $250, but it happens half way through the trade, only
about half of the potential profit will be made if the trader closes out the position.
Time decay will work in his favour in this case and the position will continue to gain
profit as time passes if SPY stays below the $260 level.
Trade management is very important, and we’ll look at that later in this post.
Breakeven Price
The breakeven price for a bear call spread is calculated as the short call strike price
plus the net credit received.
If SPY finishes exactly at $262.25 at expiry, the short call will be exercised.
The investor will be forced to buy the stock in the open market at $262.50 and then
use those shares to cover the assignment of the $260 call.
Buying at $262.25 and selling for $260 results in a loss of $2.25 per spread, but this is
exactly offset by the $2.25 premium received initially.
Of course, this ignores commissions and slippage. Some brokers will charge a fee for
assignment.
Payoff Diagram
We’ve already looked at an example of a bear call spread payoff diagram above, so I
won’t go into it in too much detail here.
The key point to remember is that the maximum profit and maximum loss are not
going to occur until right at expiry.
In the image below you can see multiple step through dates which gives you an idea
of how the trade progresses over time.
Keep in mind this does not take into account any changes in implied volatility.
Notice that even with only 2 days to expiry (T+44 line), the trade is still a decent way
from achieving max profit or max loss at prices close to the spread.
If this was to occur, the trader will be assigned on the short call, and can
simultaneously exercise the long call.
This process will mean selling the stock at the lower strike and buying the stock at the
higher strike.
The maximum loss is the difference between the two strikes, but it is reduced by the
net credit received at the outset.
Therefore, the maximum loss is the difference between the strikes x the number of
contracts x 100 – the premium received. In our example above that works out as:
It’s a pretty simple calculation once you get the hang of it, but you can download a
simple calculator below if you need some help.
I’ve created a very simple excel based calculator that can be used for both bear call
spreads and bull put spreads.
If you want a copy just click the button below, put in your email and you will get a
copy straight away.
If you have any questions on the calculator, just send me a return email and I’ll be
happy to help.
The short call will benefit from falling volatility and the long call will benefit from rising
volatility.
Therefore, the two tend to mostly offset each other.
That being said, the impact of volatility can depend on where the stock is trading in
relation to the strikes in the bear call spread.
Vega is the greek that measures a position’s exposure to changes in implied volatility.
If a position has negative vega overall, it will benefit from falling volatility.
If the position has positive vega, it will benefit from rising volatility.
You can read more about implied volatility and vega in detail here.
Looking at our example trade again, at trade initiation the position has a negative
vega exposure. All things being equal, the trade will do well if volatility drops.
The vega exposure will change as time passes and as the stock price moves.
If we fast forward to April 18th, SPY has risen to $270.82 and is above the level of our
bought call.
In this case, the vega exposure has flipped from negative to positive, so at this point in
time the trade will benefit from rising volatility.
Generally speaking, bear call spreads will have negative vega when the stock is below
the short call and positive vega when the stock is above the bought call.
Traders placing a standard out-of-the-money bear call spread will start their trade
with positive theta.
This means they will make money from time decay as time passes, with all else being
equal.
If the stock trades above the bought call, the position will switch to having negative
time decay and the passage of time will hurt the trade.
If the stock is below the short call, we want time to pass as the trade will move slowly
towards the maximum gain.
If the stock is above the bought call, the trade will move closer to the max loss as time
passes.
The trade does well when prices decline. Pretty obvious, right?
What else do we need to know about delta when it comes to trading bear call
spreads?
Well, delta can be used as a rough approximation of the probability of the underlying
stock reaching a certain level.
For example, if we sell a 10-delta call, there is a roughly 10% chance of that call option
expiring in-the-money.
Now, unfortunately it’s not quite that simple, that’s why I said roughly a 10% chance.
It’s not an exact science and there are many different variables that go into the
options pricing model.
Delta can be used as an estimate of probability and is certainly useful to know.
But, don’t assume that if you sell 20 delta puts you are going to win 80% of the time.
It doesn’t work out that way in real life.
Gamma
Gamma is one of the lesser known greeks and usually, not as important as the others.
I say usually, because you’ll see further down in this post why it can be really
important to understand gamma risk.
I won’t go into too much detail on gamma here, because it will be explained in more
detail below when we compare long-term and short-term bear call spreads.
Risks
It goes without saying that as a bearish trade, we have a risk that the price of the
underlying will rise causing an unrealized loss, or a realized loss if we close the trade.
Assignment Risk
Another risk of the trade is the risk of early assignment. While this doesn’t happen
often it can theoretically happen at any point during the trade.
For example, a trader would generally not exercise his right to buy SPY at $260 when
SPY is trading at $250 purely to receive a $0.50 dividend.
The risk is highest if the stock is trading ex-dividend and the short call is in the money.
One way to avoid assignment risk is to trade stocks that don’t pay dividends, or trade
indexes that are European style and cannot be exercised early.
However, this should not be the primary factor when determining which underlying
instrument to trade.
Otherwise, think about closing your bear call spreads before the ex-dividend date if
they are close to being in-the-money.
Expiration Risk
Leading into expiration, if the stock is trading just above or just below the short call,
the trader has expiration risk.
The risk here is that the trader might get assigned and then the stock makes an
adverse movement before he has had a chance to cover the assignment.
In this case, the best way to avoid this risk is to simply close out the spread before
expiry.
While it might be tempting to hold the spread and hope that the stock drops and
stays below the short call, the risks are high that things end badly.
Sure, the trader might get lucky, but do you really want to expose your account to
those risks?
The other major difference between the two is that the bear call spread is a credit
spread (we receive option premium) whereas the bear put spread is a debit spread
(we pay option premium).
Traders sell a bear call spread and option premium is received into the traders
account.
For a bear put spread, traders buy the spread and therefore have to pay money out of
their account.
To be honest, it really doesn’t matter because they are both almost identical trades.
Example:
Let’s use our SPY bear call spread example.
We used the $260-$265 spread and received $1,120 in premium with a max loss of
$1,380.
If instead we bought a $265-260 bear put spread, it would have cost $1,410 with a
max gain of $1,090.
In this case we would be slightly better off trading the bear call spread to the tune of
about $30.
If we compare the payoff graphs, we could also say that the bear put spread performs
better during the interim dates vs the bear call spread.
If we move forward in time to April 18th when SPY hits $270.82 the bear put spread is
-$1,045 and the bear call spread is -$1,010. So again, not a whole lot of difference.
The main thing to keep an eye on when deciding on a bear calls spread vs a bear puts
spread is the implied volatility skew.
If the calls have a high level of implied volatility compared to the puts, then a bear call
spread may be more advantageous and vice versa.
Just check the max gain and loss for each and see if there is any major difference. In
practice, most of the time, there is not going to be much difference.
Typically, traders will use bear call spreads as an income generating trade and
therefore place the spread out of the money.
Traders using the bear put spread, would usually take a more speculative view.
They might buy an out-of-the-money bear put spread, something they can do fairly
cheaply with the aim of making a large profit.
For example, rather than buying the $265-$260 spread, they might be more likely to
buy the $245-$240 spread which costs only $480 and has a max profit of $2,020.
A lot of the principals are the same as for iron condors which is covered in my free 10-
part course.
The best idea, especially when starting out, it to keep things simple.
You don’t want to overcomplicate things with too many different rules and
adjustment techniques.
There are plenty of adjustment techniques available, and I could list out 15 or so, but
sometimes it’s best to pick one or two and really master those.
Profit Target
First and foremost, it’s important to have a profit target.
That might be 50% of the credit received, 80% of the credit, or your plan may involve
holding until 100% is achieved.
One nice rule of thumb that I use – if I’ve made 50% of the profit in less than 50% of
the duration of the trade, I take the profit.
Another profit taking rule you might consider is – closing when the spread value drops
to $0.10 or $0.05.
Sometimes the opportunity cost of tying up your margin for the sake of squeezing the
last few dollars out of the trade is not worth it.
Stop Loss
Having a stop loss is also important, perhaps more so than the profit target.
Here you can set a stop loss based on percentage of the premium received OR
percentage of capital at risk.
If your profit target is 50% of premium received and your stop loss is 50% of premium
any success rate greater than 50% will see you come out ahead.
Then it’s just a numbers game and making sure you have enough trades to make sure
the statistics play out.
For example, if you sell the 10 delta call as part of your bear call spread, you might
close the trade if the delta of that option hits 25.
Each to their own, but this is all something that should be written down and mapped
out in your trading plan.
Adjustment Techniques
The first adjustment technique most traders learn is to Roll Up.
This involves buying back the spread that was initially sold and selling a new spread
further out-of-the-money within the same expiry period.
There is a cost involved with this because the spread that is being bought back will
cost more than the new one that is being sold, sometimes significantly so.
Let’s look at an example:
If we move forward to March 12th, SPY has risen to 278.50 so the underlying is sitting
above the short call.
The spread is trading at $3.11 and we are sitting with a $680 unrealized loss.
What we can do in this case is buy back the five 275-280 spreads for a total of $1,555
and sell the 280-285 spreads for $1.96 per spread or a total of $980.
We have reduced out profit potential in the trade, but we have given ourselves a bit
more room to move and once again placed our call spread out-of-the-money.
The spread can be rolled to the following month, or it can be rolled out multiple
months.
Using the same example, we buy the April 275-280 spreads for $3.11 and we roll out to
the May 275-280 spread which is trading at $3.23.
This adjustment doesn’t cost us anything and actually brings in a little bit of extra
income.
While we have brought in some extra income, using this adjustment means we are
stuck in the trade for another month.
We buy the April 275-280 spread for $3.11 and sell the May 280-285 spread for $2.43.
These are three simple adjustment techniques, all with positives and negatives.
There are many more ways to adjust bear call spreads but these three are the most
common and easiest to understand.
Short-term trades have very high gamma, which means they are very sensitive to
changes in price.
Trades with high gamma will see their delta change at a much faster rate than low
gamma trades.
If you want a full tutorial on gamma, you should read this article.
Long-term trades have a much lower gamma and therefore are not as sensitive to
changes in price.
Let’s compare a short-term and a long-term bear call spread:
Taking our SPY example from April 2nd, we’ll use the May 18th expiry trade as our
short-term trade and a Sept 21st trade using the same strikes as our long-term trade.
While the two trades are using the same strikes, the delta exposure on the short-term
trade is much higher than the long-term trade.
We can see quite clearly that short-term trades have higher greeks across the board
and will therefore see much higher P&L movement than longer-term trades.
We can see this in practice when we roll forward to April 18th when SPY had risen to
270.82 and both spreads were fully in-the-money.
The short-term trade had lost $1,010.
The trade-off of course is that the longer-term trade will see profits accrue much
slower than the short-term trade.
We have covered a lot and things are about to get a little more intense as we go
through some detailed bear call spread examples.
After this AAPL recovers and rallies slowly, but profits continue to accrue on the bear
call spread because the spread remains out of the money and time decay is picking up
steam.
The trade has achieved almost the full profit potential by April 2nd ($615 out of a
potential $675). At this point, there is little reason to hold the trade.
The small remaining profit is not worth the risk of keeping the position open for
another 18 days which also ties up margin in the account.
The following graphs show the P&L over the life of the trade:
In this example, you can see that the majority of the profits have been made very
early in the trade.
In fact by September 21st, only 20 days into the trade, $650 of a possible $700 has
been made.
At this point there is no point holding the trade for another month just to make the
last $50. It’s much better to close the trade, free up the capital and look for the next
opportunity.
3. Max Loss Scenario
In early February 2017, AAPL had experienced a huge run up in price and traders
would be forgiven for thinking that the run couldn’t go much further.
Unfortunately, that view would have been completely wrong, and a bear call spread
trader would have suffered the maximum loss.
In this instance, it’s important to realize the trade is not working early and stick to
your stop loss.
If the trader set a stop loss of 20% of capital at risk, they would have been out of the
trade within 3 days for a roughly $400 loss.
If they had taken the hope and pray approach, that $400 loss would have turned into
$1,050 loss by day 8 and then a max loss by early March.
But let’s assume that instead of closing the trade for a loss, we roll it out to February.
The January spread is trading at $2.48 so we buy to close 5 contracts for a total cost
of $1,240.
We simultaneously sell to open 5 contracts of the February 175-180 call spread which
is also trading at $2.48.
Note: This is fairly rare to be able to adjust at no cost. Normally when rolling out in
time, there will be some cost involved.
In this case AAPL was due to release earnings on February 1st, which meant the
option premiums for February were elevated compared to January.
We can see that the trade suffered an initial loss and was rolled out to the next month
eventually achieving a full gain.
At one point the trade was down over 40%. Some traders would have been stopped
out of the trade.
The decision whether to hold on to a trade like this comes down to the individual.
As we saw in the previous example a 40% loss can very quickly turn into a 100% loss.
Some traders will continue to roll out, sometimes for many months until the trade
comes back their way.
I tend not to do this because it ties up capital for a long period of time and can be
mentally draining to carry a losing trade for a long period of time.
For this trade, once AAPL did eventually drop, P&L moved very quickly with the trade
going from an $830 loss to a $500 gain in the space of 11 trading days.
The original trade when opening the spread would have been a sell to open trade, so
when closing we enter the order as a buy to close order.
Here’s an example of the opening and closing orders for a bear call spread on SPY
using Interactive Brokers.
Unfortunately, with IB it’s a little counter intuitive, because you set the spread up as a
bull call spread, and the you sell that spread.
With SPY, the bid-ask spread is quite narrow so it should be easy to get filled near the
mid-point, but what I usually do is enter my order slightly below the mid-point first
and then slowly lift the price until it gets filled.
For closing this spread, I might put the buy to close order with a price of $0.45 and
leave it for a few minutes to see if it gets filled at a slightly better price than $0.47.
Single leg options are easier to deal with, but what about if one leg of a bear call
spread gets assigned?
Firstly, the only leg that would ever get assigned is the short leg or the sold call which
is the one that is at the lower strike price.
If that happens, you could exercise your long call which would result in you buying
100 shares which would offset the short 100 shares from being assigned on the short
call.
The net position would then be zero shares and no option contracts remaining in your
account.
Doing this would only make sense if the long call was also in-the-money and had little
time value left.
The issue with this process is that it can be expensive in terms of fees and
commissions. Exercising option contracts can result in commissions of around $10 –
$15 at most brokers.
A better process is to simply buy back the shares in the open market and sell the long
call.
The result is the same and means much lower commission costs.
Either way, the loss will be about the same so I would go for the second process and
keep the costs down.
I usually try to limit the loss on spread trades to around 2 times the premium received.
Some people will recommend constantly rolling out in time and / or price and waiting
for the stock to eventually drop and the spread to expire worthless.
The losses can start to get pretty big and from a psychological perspective, I hate
carrying losing trades in my account for an extended period.
Try to limit losses to two times the credit received, and this should ensure that you are
out of the trade before it goes in-the-money.
If your spread does go in-the-money, you will need to watch out for early assignment
if there is little time value left.
I set a defined point where I will adjust my trade if it starts going against me.
1. Delta of the short call – I this starts around delta 10, I usually adjust when it gets to
20-25.
2. Stock price – I’ll decide on an adjustment point based on the chart. This could be a
resistance level or a moving average.
3. T+7 line – On the option payoff graph, I will look at the T+7 line and pick a point
where the loss is equal to the credit received.
The easiest way to adjust a bear call spread is to roll out in price.
This gives the trade more margin for error, but also reduces the profit potential in the
trade.
You can choose how much of the delta to hedge based on how much protection you
want against a further adverse move.
This gives the position a funny looking expiration graph but a much better T+7 line.
If the stock starts to drop, I then sell the shares back at a small loss and continue
holding the original call spread.
Adding a calendar spread over the short call
Instead of hedging the SPY short call spread with shares, let’s look at using a calendar
spread to create a profit zone around the short call.
This can be a good adjustment strategy if you are very confident that the underlying
stock will not rise above the short call.
It doesn’t reduce the delta exposure as much as the previous example but will give
some protection and has the added benefit of adding positive vega and increasing
theta.
There are lots of other ways to adjust bear call spreads that are under pressure, but
these are two that I use quite frequently.
Summary
Selling bear call spreads is a popular trade with income investors who have a
neutral to bearish view on a stock.
Bear call spreads are defined risk, defined profit trades.
The impact of volatility and time decay can vary depending on whether the trade
is in-the-money or out-of-the-money.
P&L on short-term trades will fluctuate much more than on long-term trades.
Adjustment strategies can be used to turn losing trades into winning trades, but
they don’t work every time and can involve more risk.
Trade Safe!
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JAI KASTHURI