Bear Call Spread

Bear call spread, also called short call spread or credit call spread, consists of a short call option with lower strike price and a long call option with higher strike and same expiration. It is a bearish strategy (profits when underlying price goes down). Like other vertical spreads, it has limited risk (equal to strike difference minus initial cash inflow) and limited potential profit (equal to initial cash inflow). It is the inverse (the other side) of bull call spread.

Setup

To create a bear call spread:

  1. Sell a call option (more on strike selection below).
  2. Buy a call option with higher strike, on the same underlying, with same expiration date.

Two important things define a bear call spread:

  • Both options have the same expiration date (it is a vertical spread).
  • The long call has higher strike than the short call (otherwise it would be a bull call spread).

Cash Flow

Bear call spread is a credit strategy. Initial cash flow is positive, because the lower strike call option being sold is more expensive than the higher strike call being bought.

Initial CF = short lower strike call price – long higher strike call price

The idea behind the strategy is to short a call option and protect the position against the otherwise unlimited loss by buying a cheaper, higher strike call option.

Payoff at Expiration

There are three different scenarios at expiration. Because the strategy is the inverse of (short position in) a bull call spread, the scenarios are the same, only with opposite sign (profits are losses and vice-versa).

Maximum Loss

Maximum loss from a bear call spread occurs when underlying price ends up at or above the higher strike at expiration. Negative payoff from the short lower strike call (underlying price minus lower strike) is partially offset by positive payoff from the long higher strike call (underlying price minus higher strike). Net payoff at expiration is negative and equals the strike difference. Total loss is reduced by positive initial cash flow.

Maximum Profit

Maximum profit occurs when underlying price ends up at or below both strikes and both options expire worthless. There is zero payoff at expiration, but we keep the positive initial cash flow.

Break-Even Point

When underlying price ends up between the two strikes, the trade results in either profit or loss. Bear call spread break-even point is exactly the same as bull call spread break-even, as the two strategies are just two sides of the same position. The break-even is when:

Lower strike call payoff = initial cash inflow

B/E underlying price – lower strike = short lower strike call price – long higher strike call price

B/E = lower strike + short lower strike call price – long higher strike call price

Unlike bull call spread, bear call spread is profitable below the break-even, and loses money above it.

For more details and examples of payoff calculation, see Bear Call Spread Payoff, Break-Even and R/R.

When to Trade

Main objective with a bear call spread position is for underlying price to end up below the short call strike, where the option expires worthless. It is a suitable strategy when we expect the underlying to moderately decline, or at least not rise. It is like a short call, but hedged with the long higher strike call.

Like other vertical spreads, the position can be constructed with different exposures to time and volatility. It can be done in such way that these exposures are close to zero and the spread is purely a directional play, or it can be used to speculate on both underlying direction and volatility. This is decided by strike selection.

Strike Selection

We can break down the strike selection decision in two parts:

  1. Where = Which strikes relative to current underlying price.
  2. How wide = How big distance between the two strikes.

With the first decision we have three possibilities:

  1. Both strikes above current underlying price.
  2. Both strikes below.
  3. Short strike below and long strike above.

Both Strikes above Underlying Price

This kind of bear call spread is probably the most common. Its objective is for underlying price to not rise above the short lower strike. Unless that happens, even if underlying price stays the same, we make maximum profit (i.e. keep the entire net premium received). Therefore, besides favorable (downward) moves in underlying price, the position also profits from passing time (it has positive theta) and decreasing volatility (negative vega).

This is because the short lower strike call is closer to the money and has greater time value, which also decays faster and is more sensitive (in absolute dollar terms, not percentages) to changes in volatility.

Both Strikes below Underlying Price

The opposite kind of bear call spread is when both strikes are below underlying price when opening the position, and both options are in the money initially. If price stays like that until expiration, the position results in maximum loss (initial cash inflow minus difference between strikes).

Therefore, we need the market to move (below the lower strike or at least below the break-even point). We want volatility, while time works against us. This bear call spread has positive vega and negative theta, because the long call is closer to the money now, and its time value is bigger.

Compared to the first type, this spread has greater initial cash inflow (both options are in the money, therefore more expensive, and also the difference between their premiums is greater). Therefore, it has greater potential profit and smaller maximum loss, other things (strike distance) being equal. The downside is that it needs the market to move to turn profitable, and decays with time.

Underlying Price between Strikes

In between the two above types is the spread with the short strike below and long strike above current underlying price. Its exposure to time and volatility depends on the relative distances of each strike from underlying price. If the short strike is closer, it is short volatility and long time, and vice versa.

To create a clean, volatility neutral, directional exposure, it is best to choose two strikes with equal distance from underlying price. In this case, the time value of both options will be approximately the same, and total theta and vega will be close to zero. This can change as underlying price moves; therefore, we may need to adjust the position if we want to keep it volatility neutral.

Strike Distance

Distance between the long and short strike affects risk and payoff profile in the same way as with other vertical spreads. If they are closer together, the difference in premiums is smaller (resulting in smaller initial cash inflow and potential profit), but the smaller strike distance also limits the potential for losses.

Conversely, choosing strikes further apart creates a spread with greater risk and greater profit potential.

Summary

  • If you expect price to not rise, but not necessarily fall, choose higher strikes.
  • If you expect price to fall and volatility to possibly increase, choose lower strikes.
  • If you want the position neutral on time and volatility, choose two strikes with same distance from underlying price (short strike below, long strike above).
  • For smaller risk (but also smaller profit potential), choose strikes close together.
  • For more profit potential (but also greater risk), choose strikes further apart.

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