What is bear call spread?

Last Updated: 4 Apr 2024

As every investor has a different risk exposure and knowledge, their trading style and the chosen asset class differ. Traders with a higher risk appetite and extensive financial knowledge choose Options trading, which is a part of derivative trading. Within Options trading, you can choose between numerous products and trading techniques, one of which is bear call spread. It allows you to limit your risk exposure and earn profits through the premium amount given to every options seller by the buyer.

However, to understand bear call spread, you need to know options trading and some general terms associated with bear call spread strategy.

What is Options Trading?

Options are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expiration at a fixed price. Options can be acquired with brokers such as IIFL through online trading accounts as with any other asset group.

You can buy or sell stocks, ETFs, etc., at a fixed price over time through online trading options. This online trading method also gives buyers the flexibility not to purchase the security at the defined price or date. Although it’s a little more complex than stock trading, options yield comparatively greater returns if the security price goes up. This is because you do not have to pay the full premium for the insurance of an options contract. Similarly, selling options will reduce your losses if the security price goes down, which is called hedging.

Types of Options Contract

Call Options

This is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties. Since there is no obligation to purchase as dictated by the call option, you do not need to execute it unless it is profitable to you.

Put Options

A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock on the date agreed upon by the contracting parties.

Some terms associated with bear call spread

There are many terms associated with bear call spread:

• Strike Price: The price at which the options contract was initially bought or the pre-determined price.
• Spot Price: The current price of the underlying asset attached to the call option contract.
• Premium: It is the price you pay to the seller of the option for entering into the online trading options.
• In-The-Money (ITM) call option: When the underlying asset price is higher than the strike price.
• Out-of-the-money (OTM) call option: When the underlying asset price is lower than the strike price.

What is Bear Call Spread?

A bear call spread is a two-legged options trading technique that involves selling a call option with a lower strike price to collect an upfront premium and simultaneously buying a new call option with a higher strike price. The underlying asset and the expiration date in both contracts are the same.

The idea is to profit from the premium amount. As the premium for a short call (an options contract with a lower strike price) is higher than the premium amount of a call option contract with a higher strike price, the investors realize profits in between.

Investors use a bear call spread if they think that the price of a stock or the underlying asset will reduce moderately shortly. The bear call spread strategy is also known as credit call spread or short call spread.

An example of a Bear call spread

Options trading and especially a bear call spread strategy can seem complex if you are a new investor. Without proper knowledge about the way it works, you can lose a good amount of money while exercising a bear call spread.

Here is an extended example to understand bear call spread in detail:

Consider a company called XYZ, whose stock is trading at Rs 27. If you think that the price of the stock of XYZ will go down in a few days, you can initiate a bear call spread on the company. The following is the information about its options contract and the premium:

1. July 30 call – Rs 1

2. July 25 call – Rs 3

The Lot size is 100 shares.

An investor initiating a bear call spread can do the following transaction:

Net profit = Rs 200 (300-100).

Now, the three possible scenarios can arise in the bear call strategy:

Scenario 1: The stock price remains unchanged at Rs 27

• Buy July 30 Call: Expires worthless
• Sell July 25 Call: Expires worthless
• Total profit = Rs 200 (the initial difference between the received and paid premium)

Scenario 2: Stock price goes up to Rs 35

• Buy July 30 Call: Expires in the money with a value of (35-30)x100 = Rs 500
• Sell July 25 Call: Expires in the money with a value of (25-35)x100 = Rs -1000
• The net initial premium was Rs 200.
• Total Loss = -1000+500+200 = Rs -300

Scenario 3: The stock price falls to Rs 20

• Buy July 30 Call: Expires worthless
• Sell July 25 Call: Expires worthless
• Total profit = Rs 200 (the initial difference between the received and paid premium)

Advantages and Disadvantages of a bear call spread

Advantages

• Investors can earn a premium income with lesser risk exposure.
• As most of the contracts expire worthlessly, there are fewer chances of losses.
• Investors can hedge against volatility and realize profits if the price goes down.
• Bear call spread has a lower margin required when compared to naked calls.

Disadvantages

• The premium income is not significant when compared to the risk level.
• Volatility can go either way and result in considerable losses if the asset price rises.
• It is very hard to determine the price trend of assets which may result in losses.
• Bear call spread requires extensive knowledge of the options trading market.

If you think the market is bearish and will go further down, a bear call spread can prove to be a highly profitable options trading strategy to realize profits through the premium amount. If you are interested in options trading, you can visit the IIFL’s website to open a free Demat and trading account. You can also download IIFL’s Markets app from the app store to open the accounts.

Given the bear call strategy’s risk exposure, it is always wise to consult financial advisors such as IIFLs to understand bear call spread strategies in detail and ensure you realize good profits and mitigate your losses. Also, checkout our put call ratio indicator and learn about the market sentiments in the trading world.

Frequently Asked Questions

How is a bear call spread calculated?

Here is how you can calculate your bear call spread:

Maximum Loss: Difference between call options strike prices – net received premium + commissions paid.

Maximum Profit: Net received premium – commissions paid.

No Profit/No Loss: Strike price of the sold call + net received premium.

How to adjust bear call spread?

You can consider the following factors to adjust a bear call spread:

• The time frame
• Short and long leg
• The take-profit level
• When to hedge
• When to roll
• When to exit the trade