Bear Put Spread Introduction
If you simultaneously buy and sell options with different strike prices you are establishing a spread position. If a market is relatively volatile and you feel it maintains a general negative tone, sometimes a Bear Call Spread can become an attractive options spread strategy. This bearish strategy is similar to selling naked calls, in that it puts premium into your account when you establish the position. It becomes profitable when the stock price moves below the break-even point, which is the lower strike price plus the net credit balance.
This strategy works best when the range traded is somewhat limited. The purpose of the spread is to provide limited downside risk but we also limit our profit potential in doing so. You use this strategy when you are moderately confident of a drop in the underlying asset and you want some kind of protection and profit should the underlying asset remain stagnant in its trading movements. Hopefully your stock is a bit more likely to fall than rise during the option time range. The Bear Call Spread strategy is a good position to be in if you find yourself wanting to be in a stock but are unsure of bearish expectations.
This strategy is considered moderately bearish because the investor is using the sale of a call to reduce his or her risk while still positioning for a decent profit should the stock price move below the lower strike price.
One reason why a trader use calls instead of puts is to take advantage of options that are viewed as overpriced. Since the trader is selling the spread, the receipt of higher premiums is a benefit. There can also be greater liquidity in calls than puts which gives greater flexibility when entering and exiting the spread.
The maximum loss potential is realized if the stock moves above the out-of-the-money or higher call option strike price.
Definition: Credit Spread Position
A Credit Spread is an options strategy where a high premium option is sold and a low premium option is bought on the same underlying security. A Bear Call spread is a credit spread created by purchasing a higher strike call and selling a lower strike call with the same expiration dates. Some call these “vertical credit spreads” because they use the same expiration cycle. Vertical credit spreads can be either Bear Call spreads or Bull Put spreads.
A Bear Call Spread is the purchase of an out-of-the-money (higher) call option while simultaneously selling the in-the money (lower) call option on the same underlying stock. You can make money if the underlying asset stays stagnant through the decay and expiration of the more expensive short call options.
Because the sale of the in-the-money (lower) strike price brings in cash flow greater than the cost of the out-of-the-money (higher) buy call option position, it is considered a "Credit Spread." To emphasize this point, if a spread position takes in more through the sale of one call option position than it costs to purchase the other call option position, it is a credit spread. If the opposite were true (the call purchase position costs more than the sale of the other call position), it is a "Debit Spread." A Debit Spread occurs with Bull Call Spreads and Bear Put Spreads. A Bear Call Spread position is always considered a Credit Spread because the sale of the in-the-money (lower) call options takes in more than it costs to purchase the out-of-the-money (higher) call options.
Investor Sentiment:
The Bear Call strategy is considered a moderately bearish strategy because you profit if the underlying stock price decreases. The more bearish a trader, the more inclined to look for lower strikes to select. This gives one more credit and requires more substantial stock price downward movement to realize the profit potential.
Profit Potential:
There are two ways a Bear Call Spread can become profitable. If the stock goes down, the short call option goes down in price and will eventually expire out of the money when the underlying asset drops beyond the strike price of the short call option. While the underlying asset stays stagnant, the premium on the more expensive short call option will continue to decay until it has no value thereby allowing one to pocket the price of the short option.
Because it is a credit spread the maximum profit potential of a Bear Call Spread is the net credit gained when the position is put on. This occurs when the short call option expires out of the money.
Risks:
If the stock price increases above the out-of-the-money call option strike price at the expiration date, then the investor will experience maximum loss. (the difference between the two strike prices minus the net credit received when the spread was established)
Advantages:
· Loss is limited if the underlying financial instrument rises instead of falls.
· The profit potential will be greater than just buying put options if the underlying instrument fails to drop beyond the strike price of the out of the money short call option.
· Able to profit even when the underlying asset remains completely stagnant.
· Lower risk than simply writing naked call options as maximum downside is limited by the long ATM/OTM call option.
Disadvantages:
· No additional profits will be possible if the underlying asset drops beyond the strike price of the short call option.
· As long as the short call options remain in the money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the short call obligation.
· Margin requirements required to put on the position because it is a credit spread.
· Possibly more commission expenses.
Profit / Loss Summary:
Net credit = money received from selling in-the-money call options - money paid for buying out-of-the-money call options
Maximum profit potential = net credit received (limited)
Maximum loss potential = difference between strike prices - net credit received (limited)