Understanding the Bear Call Spread Strategy in Option Trading.

Bearish investors often look for ways to minimize risks and earn some returns. They usually make benefits expecting that the market price will dip. Options traders with a bearish attitude can use the technique to earn returns. It is the perfect strategy when you expect a modest or marginal dip in the asset’s market value. Read on to understand what is a bear call spread and when to use it.

What is a Bear Call Spread?

As discussed above, a bear call spread is a two-legged, bearish trading strategy for options investors. It involves simultaneously purchasing and selling call options with the same expiration date. You might already know that a call option provides the holder the right to buy the underlying asset at a strike price of the contract’s expiry date. This strategy involves selling a call option and purchasing one with a higher strike price. Investors earn from the premium collected on the short call. Investors receive the premium upfront on the short call with a lower strike price.

When is a Bear Call Spread Strategy Useful?

Before we discuss the bear call spread formula, it is essential to discuss its uses. It is perfect for markets with modest declines in prices. It might not work effectively where there is a significant decline in asset prices. When there is a significant decline in the price, the difference between the strike prices of calls is greater, thus leading to more losses. If you expect a major decline in the market, it is better to use short sales, bear put spread, and other strategies.

It can be used in markets with high volatility , especially implied volatility. Long and short calls in the spread can minimize the risks of volatility. When implied volatility, investors are uncertain of future price fluctuations for an asset. However, it means more investors will look for options to secure their positions. As a result, you can receive more premium on selling a call option.

The bear call spread strategy helps manage portfolio risks and earn returns. You might fail to manage the risks with only a single call option. Selling a call option will give the buyer the right to purchase securities at the strike price. If the market prices rise significantly, the holder will exercise the contract. As a result, you must now sell the underlying asset to the call option holder at a lower price than the market.

Bear Call Spread Calculations

Before you implement this strategy, use these formulas to calculate the maximum possible losses and profits:

Maximum Profit = Premium received – premium paid

Maximum Loss = (Strike price of the long call – strike price of the short call) – net premium

Let us take a bear call spread example for clear understanding. Let us say you have purchased a call based on a stock (20 shares) at a strike price of Rs 100. The premium paid for the call option is Rs 15 per share. You also sell a call with the same expiration date and underlying asset. However, the strike price for the short call is Rs 85. The premium received is Rs 25 per share. In this case, the maximum profit is Rs 200 (25*20 – 15*20). The maximum loss you can encounter in the above example is Rs 185.

Advantages of Using a Bear Call Spread Strategy

There are several pros associated with this strategy. You can earn from the net premium and don’t have to take huge risks for the premium income. On the other hand, a naked call option might not minimise the risks as effectively. 

This strategy takes advantage of the time decay to make a profit. When the price drops marginally, both options might go unexercised. As a result, the investor gets to keep the premium collected on shorting a call option. The value of a call option will decline with time, thus allowing the investor to benefit from contract expiration.

Recommended Read: What is the Put Call Ratio?

This strategy can be tailored according to one’s needs. You can change the strike prices of short and long calls to suit your objectives. Also, it can be easily implemented, even by newcomers in the market.

Limitations of Bear Call Spread

Even though bear call spread has certain advantages, there are many limitations. For instance, it might not work effectively when the price decline is significant. Your maximum loss would increase when prices drop significantly. Also, the returns are limited to the net premium received. However, it also caps the maximum losses, which helps investors take fewer risks. You might also experience more losses when the asset’s market value rises significantly. Investors must choose the same expiration date and quantity of the asset for both call options. Discrepancies in the expiration date or asset quantity might lead to a loss.

Conclusion

Bear call spread is an excellent bearish trading strategy for markets with marginal price movements. If you expect a small asset price decline, you can use this strategy. It helps you earn from the premium received on writing off the call option. Ensuring that the expiration date is the same for both calls in a bear call spread is crucial. Start implementing the bear call spread strategy today!