Bear Call Spread
A Bear Call Spread is a type of vertical spread. It contains two Calls with the same expiration but different strikes. The strike price of the short Call is below the strike of the long Call, which means this strategy will always generate a net cash inflow (net credit) at the outset.
Market Outlook
Moderately bearish to bearish sentiment among market participants.
When to Use
An investor often employs the bear call spread in moderately bearish market environments, and wants to capitalize on a modest decrease in price of the underlying stock. If the investor’s opinion is very bearish on a stock it will generally prove more profitable to make a simple put purchase.
Profit & Loss Chart
Benefit
The bear call spread can be considered a doubly hedged strategy. The price paid for the call with the higher strike price is partially offset by the premium received from writing the call with a lower strike price. Thus, the investor’s investment in the long call and the risk of losing the entire premium paid for it, is reduced or hedged.
On the other hand, the long call with the higher strike price caps or hedges the financial risk of the written call with the lower strike price. If the investor is assigned an exercise notice on the written call, and must purchase an equivalent number of underlying shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace. The premium received from the call’s sale can partially offset the cost of purchasing the shares from the assignment. The net cost to the investor will generally be a price less than current market prices. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy.
Risk & Reward
Maximum Gain: Limited
Maximum Loss: Limited
The maximum gain is limited. The best that can happen is for the stock price to be below the lower strike at expiration. The upper limit of profitability is reached at that point, even if the stock were to decline further. Assuming the stock price is below both strike prices at expiration, the investor would exercise the long Put component and presumably be assigned on the short Put. So, the stock is sold at the higher (long Put strike) price and simultaneously bought at the lower (short Put strike) price. The maximum profit then is the difference between the two strike prices, less the initial outlay (the debit) paid to establish the spread.
The maximum loss is limited. The worst that can happen at expiration is for the stock to be above the higher (long Put) strike price. In that case, both Put options expire worthless, and the loss incurred is simply the initial outlay for the position (the debit).
Break Even Point
Long Put strike – Net Debit Paid
Volatility Changes
Increase In Volatility: Effects Vary
Decrease In Volatility: Effects Vary
Time Decay (Theta)
Effect Varies
The passage of time hurts the position, though not quite as much as it does an plain long Put position. Since the strategy involves being long one Put and short another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.
Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be somewhat of a negative. This strategy requires a non-refundable initial investment. If there are to be any returns on the investment, they must be realized by expiration. As expiration nears, so does the deadline for achieving any profits.
