Bear Call Spread
This should always be considered a short-term bearish strategy. Spread traders will be looking to place these trades between 30-45 days prior to expiration. Since they are the seller of these options, they want to give the buyer as little time as possible to be right on the trade. That’s the beauty of this type of trading. Spread trader have the ability to make a nice living selling options to speculators who are hoping for the stock to reverse it’s downward trend and move higher… not likely! A spread traders job is to locate stocks that are in a downtrend, and then wait patiently for the proper trade set up. Once they place the trade, their goal is to have the stock price close on expiration day below the option strike price that they sold. Key Point: bring the money in, and keep it!
Spread traders will be using this type of spread when they are bearish (optimistic that the downtrend will continue) to neutral on a particular stock that has options to trade. Under no circumstances do they ever place this trade when they are bullish on a stock. It’s called a credit spread because they will be bringing a credit into their account by selling the most expensive option closest to the stock price, and buying the option directly above it. It seems complicated when you’re first introduced to it, but after paper trading for a few months, most traders are able to place these trades with lighting speed.
Here’s an example on a hypothetical stock:
You have identified that ABC Stock is in strong downtrend, and it has just bounced off major resistance and is beginning to head lower fast. Being a decisive trader, you check the news to make sure nothing positive is about to happen to reverse the downtrend. Time to get into the game! The stock price is currently trading at $100.00. Here is how this trade will play out.
- Ticker: ABC
- Current Price: $100.00
- Buy 1 – 110 call option for $.45
- Sell 1 – 105 call option for $1.25
- Net Credit (Maximum Profit) is .80 cents
- Maximum Risk $4.20
- ROI is Credit / Risk or .80 / $4.20 = 19%
What the goal of this trade? To bring cash in (credit), and keep it!
You now want the stock to continue its downtrend and close below the 105 call option on expiration day (for monthly options, it’s the 3rd Friday of every month). If that happens, you do nothing and keep the credit you brought in. Life is good, and Credit Spreads are sweet!
Your risk decreases (and so does your credit) if you sell further away from the current stock price. If you sold the 110 instead of the 105 you may only have a credit of say .25 or a ROI of 6% on this trade. Individual traders must decide for themselves how much risk they are willing to take.
Of course, there is a little more to it than that. The previous example was intended to get your feet wet with the idea of how a bear call spread works.
Benefits of Bear Call Spreads:
Higher probability of success. When traders sell options that are out of the money (OTM), they can benefit on the time decay of the option. 99% of the time they will be selling options with no intrinsic value, only time value. With a Bear Call Spread they are able to profit in three different market movements unlike the buyer of the option, who only profits if the stock moves in the direction they choose.
Monthly Cash Flow. As I’ve mentioned before, savvy spread traders use their trading account to supplement their income. And now that traders can trade credit spreads using weekly options… supplementing their income is even easier. When traders place a credit spread, the cash comes into their account the day they sell the option. They get paid upfront.
Low Risk. traders know exactly how much they have at risk before they place the trade. Traders figure their risk by taking the spread amount between the strike price they sold and the one they bought, and minus the credit. In the above example there was a risk of $4.20. They bought the 110 and sold the 105, which is a difference of 5. They then minus the credit of .80, which gives them their risk of $4.20.
On a Bear Call Spread, their only goal is to have it close below the strike price of the call option that they sold.