Updated: Nov 29, 2020
BEAR CALL SPREAD
Strategy Type: Moderately bearish
# of legs: 2 (Long OTM, higher strike Call + Short OTM, lower strike Call)
Maximum Reward: Premium of short Call - Premium of long Call
Maximum Risk: (Strike price of long Call - Strike price of short Call) - (Premium of short Call - Premium of long Call)
Breakeven Price: Strike price of short Call + Premium of short Call - Premium of long Call
Payoff Calculation: Payoff of Long Call + Payoff of Short Call
Explanation of the Strategy
A Bear Call Spread is a two-legged strategy wherein the trader would sell an OTM Call option and simultaneously buy an OTM Call option for the same underlying and same expiration. The Call that is sold will have a lower strike price, while the Call that is purchased will have a higher strike price. Put it in other words, the strike price of the short Call will be below that of the long Call. This a moderately bearish strategy, wherein the trader benefits when the underlying price either consolidates or declines. Unlike a Bull Call Spread which is a net debit strategy, a Bear Call Spread is a net credit strategy. This is because the premium received on shorting the Call is higher than the premium paid on buying the Call. The trader who executes this strategy gets to retain the entire net credit of the strategy as long as the underlying price is trading below the strike price of the short Call. This is one of the reasons why an OTM Call is written, because it gives the trader some leeway between the current market price and the short Call strike price. Meanwhile, once the underlying price rises above the strike price of the short Call, the trader’s net credit received starts reducing until the underlying price reaches the breakeven price of the strategy, which is a point of no profit, no loss. Once the underlying price moves above the breakeven price, the trader starts suffering losses.
Compare this strategy to a naked short Call strategy. In shorting a Call naked, the risk is potentially unlimited because there is no limit to the extent to which the underlying price can rally. By executing a Bear Call Spread, the long Call acts as an insurance to the short Call. This is because if the underlying price rises and crosses the strike price of the long Call, the trader’s losses get capped at that strike. Beyond this, no matter how higher the underlying price rallies, the trader does not incur any more losses. Hence, by paying a small premium, the trader is protecting his/her position against any sharp, adverse price move.
Benefits of the Strategy
If used in correct market conditions, the strategy can be a good source of income
The strategy achieves its maximum profit potential even if the underlying price does not move
The maximum loss in this strategy is capped, no matter how higher the underlying price moves above the breakeven price
Depending on your risk-reward expectations, you can adjust the strike prices that you choose for going long and short.
Drawbacks of the Strategy
The maximum reward is limited to the extent of the net credit received
If the underlying price falls sharply, there would be an opportunity loss
The risk-reward profile is unfavorable as risk is usually greater than reward
Ensure that the price trajectory of the underlying is sideways or moderately bearish
If you are outrightly bearish on the underlying, then you would be better off by deploying other strategies such as long Put or short futures
Have conviction that the underlying price will stay below the strike price of the short Call
Select the strikes depending on how much you expect the underlying price to move
A general rule to remember is the larger the difference between the two strikes, the larger would be the reward and so would be the risk, and vice versa
So, if you want reward over safety, select strikes that are far away from each other, and vice versa
Option Greeks for Bear Call Spread
GreekValue is Notes Delta Negative Because the strategy involves selling an OTM Call with a lower strike and buying anOTM Call with a higher strike, the overall Delta is negative. As a result, the position stands to benefit when the underlying price falls, and vice versa. Delta reaches zero when the underlying price either falls sharply below the lower strike or rises sharply above the higher strike. Meanwhile, Delta is at its maximum negative value when the underlying price is in between the two strikes.
Gamma Negative At initiation, the position Gamma is negative, causing the position Delta to decrease (become more negative) for a given rise in the underlying price, and vice versa. However, once the underlying price rises beyond the breakeven price, the position Gamma becomes positive, causing the position Delta to increase (become less negative) for a given rise in the underlying price, and vice versa. Meanwhile, when the position is deep ITM or deep OTM, Gamma approaches zero.
VegaNegative When the strategy is initiated, the overall Vega is negative, meaning rising volatility hurts the position, and vice versa. Once the underlying price rises above the midpoint of the two strikes, the overall Vega becomes positive, meaning rising volatility helps the position, and vice versa. Meanwhile, Vega reaches zero when the underlying price either falls sharply below the lower strike or rises sharply above the higher strike.
Theta Positive The overall Theta is positive at initiation, meaning time decay benefits the position as long as the underlying price is below the breakeven price.Once the underlying price rises and moves beyond the breakeven price, Theta becomes negative, meaning time decay starts hurting the position.
Rho NegativeThe overall Rho is negative at initiation. As a result, rising interest rates hurt the position, and vice versa. However, it must be noted that this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Bear Call Spread
The above is the payoff chart of a Bear Call Spread. Usually, this strategy is traded by selling an OTM, lower strike Call and buying an OTM, higher strike Call. As a result, this is an income strategy, wherein the trader receives a net credit into his/her trading account. Notice in the chart that the maximum gain under this strategy is limited to the extent of the net credit received. The trader is in a profitable position as long as the underlying price is trading below the breakeven price of the strategy. Once the underlying price crosses the breakeven price, the trader starts incurring losses. Unlike a naked short Call however, losses are not unlimited. The Call that has been bought at higher strike acts as a ceiling, beyond which losses will not increase. Keep in mind that this strategy must be deployed only when your outlook on the underlying is range bound to moderately bearish. If you expect the underlying to fall sharply, you have to look out for other bearish strategies where the profit potential is unlimited, such as a long Put.
Example of Bear Call Spread
Let us assume that Bank Nifty has broken below a minor support of 20000 and is currently trading at 19850. Mr. ABC is of the opinion that the index will head slightly lower in the days ahead towards its key support level of 19000. Based on this, ABC decides to enter into a Bear Call Spread strategy, wherein he will sell anOTM 20000 strike Call option and simultaneously buy an OTM 21000 strike Call option. Let us assume that the premium on the lower strike Call is ₹200 and that on the higher strike Call is ₹140. Given that he would be receiving a premium of ₹200 and paying a premium of ₹140, the net credit into his trading account would amount to ₹60. Given the lot size of 20, the total net credit would amount to ₹1,200. Let us summarize the details below:
Strike price of short Call = 20000 CE
Strike price of long Call = 21000 CE
Short Call premium = ₹200
Long Call premium = ₹140
Net Credit = ₹60
Net Credit (in value terms) = ₹1,200
Breakeven price of the strategy = ₹20,060 (20000 + 200 - 140)