The Bear Call Credit Spread – A Neutral Bearish Strategy That Outperforms Selling Naked Options
In this article, we will learn one of the most interesting option trading strategies, called the credit call spread.
Here, we will learn how a bear call credit spread works, we will analyze the risk-reward ratio when the expiration date arrives, and we will discuss the maximum profit and maximum loss that we can find in this option strategy.
Table of Contents
What is a bear call spread?
A bear call credit spread is an options trading strategy composed of two calls, one bought and another one sold.
It is called credit spread because the call contract that we are selling will be more expensive than the one we will be buying, so we will receive a net difference in our portfolio, or a credit.
When to use the bear call spread?
The bear call credit spread strategy aims to ensure that the underlying price does not increase above the strike prices at which we have opened the trade.
So, in other words, we should be using this strategy when we are bearish or neutral over the market, and we wish to sell options without an unlimited risk.
To help us identify the state of the active, the best thing we can do is to use a technical analysis tool, such as the ADX indicator, which will help us to spot if there is a trend active or not in the market.
How is the bear call credit spread composed?
As with the other spread strategies, this one has a limited profit and loss mechanism, so we will be eliminating many of the drawbacks of selling naked options.
Specifically, the bear call credit spread strategy aims to ensure that the underlying price does not increase above the strike prices at which we have opened the trade, only. On the expiration date, we will not care whether the underlying asset has fallen or remained where it was.
As long as it does not increase above the strikes, the strategy will be a winner trade.
Besides, the bear call credit spread inherits many of the advantages of selling options, and the time decay is beneficial to our trade.
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What do we exactly need to compose the bear call credit spread?
The position consists of selling a call contract with a strike price below the strike price of the second call contract, which is bought. This way, every time we open a trade, we will be receiving money, since the strike we buy will always be cheaper than the one we have sold.
Let us take a look at a bear call spread example to see how this works.
Bear call spread example
Let us imagine that we want to carry out an options trading operation on the company General Motors. Since we have analyzed the market, we know that prices will not go above $25 during the next three weeks.
In this bear call spread example, we are going to assume that the underlying is currently at $24. We decide to open a bear call credit spread, which will consist of selling a call at a strike price of $24 while buying another call at $26 for a 21 expiration date. Let us take a look at the bear call spread calculator.
Therefore, we will have to pay $8 for the strike bought, while we will receive $61 for the one sold. Thus, the bear call credit spread will result in a credit of $53 in total for each of the bear call spreads we decide to purchase.
Bear call spread payoff diagram
In this strategy, we will profit as the underlying loses its value.
Since this option strategy is based on the fact that selling is the predominant force, the bear call credit spread inherits most of the advantages of selling options. That means we will profit from time decay, since what we want the underlying not to rise.
As time goes by, our position will gain value because the prices of both options will fall. Therefore, the bear call spread payoff diagram will be better and better until the expiration date. Let us take a look now at the bear call spread graph at the expiration date.
Bear call spread graph at the expiration date
Breaking down the credit call spread option strategy
As you can see, we have two scenarios at the extremes.
If the underlying falls below the lowest strike, i.e., $24, we will keep the full premium we received at the opening of the trade. In other words, we will have made a maximum profit of $53.
However, if the underlying increases above the highest strike price, which turns out to be $26, we will have obtained the maximum loss, as we will be assigned the $24 strike. The losses, in this case, will result from subtracting the upper strike price minus the premium obtained.
Therefore, we will get a loss of $200, and we will have to deduct $53 from the premium we received when we opened the trade. Let us now check the bear call spread payoff table so we can have a better view.
Bear call spread payoff table
However, if the underlying falls between the two strikes we picked to open the bear call credit spread, depending on the underlying price, we will obtain a profit or a loss.
Our break-even point would be obtained by adding the premium received to the lowest strike. That is, in this example, it is $24.53.
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Last words about the credit bear call spread strategy
As you can see, unlike many other option strategies, the bear call spread strategy tries to limit the loss that is obtained when selling the simple option contracts in exchange for reducing a certain value of the maximum profit obtained.
The great advantage of the bear call spread strategy is we want the underlying to not increase against us, regardless of whether the value stays where it is or drops in our favor, so we can keep the premium as a profit with a much higher probability.
The bear call spread is a strategy that, together with the bull put credit spread, enters the category of credit spread, since, when opening a transaction of this nature, we will directly obtain a profit.
