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This is a credit trade when initiated and makes money when the market closes below the strike of the short optionBEAR CALL SPREAD A bear call spread consists of selling a lower strike call and buying a higher strike call using the same number of options and identical expiration dates. This is a credit trade when initiated and makes money when the market closes below the strike of the short option. This strategy is used when you have a bearish view of a market. It offers a limited profit potential with limited risk. The maximum reward is achieved when the closing price of the underlying security is below the lower strike call, yielding the full net credit for the trade. Therefore, this trade should be implemented by selling options that have a high probability of expiring worthless so you can keep the net credit. The maximum risk is equal to the difference between strike prices minus the net credit times 100. The maximum risk occurs when the stock or futures contract closes at or above the strike price of the option purchased. This means that the short option will have increased in value while the one purchased has not increased in value as much. The breakeven is calculated by adding the strike price of the lower call to the net credit received. Bear Call Spread Example Lets say XYZ is trading at $51 and you think its ready for a correction. You decide to initiate a bear call spread by going short 1 XYZ June 50 Call @ 3.50 and long 1 XYZ June 55 Call @ 1.00. When you initiate this trade, you receive a credit of 2.50, or $250 per contract: (3.50 - 1.00) 100 = $250. This is the maximum reward that would be earned at expiration if XYZ closes at or below $50 per share. Since the maximum risk is equal to the difference between strike prices minus the net credit, the most you can lose in this example is $250: (55 - 50) - 2.50 100 = $250. Maximum risk occurs if XYZ closes at or above 55. The short option would have a value of 5: (55 - 50 = 5). The long 55 call would expire worthless; therefore, your position would lose 5 points, or $500 if the position closes at the higher strike price. However, you received a credit of $250; therefore, your risk is a net $250: ($500 $250 = $250). The breakeven on this trade occurs when the underlying stock price equals the lower strike price plus the net credit. In this trade, the breakeven is 52.50: (50 + 2.50 = 52.50). The trade breaks even or makes money as long as XYZ does not go above 52.50 at expiration. The risk graph of this trade is shown in Figure 5.7. The risk graph of a bear call spread slants downward from left to right, displaying its bearish bias. If the underlying shares fall to the strike price of the short call, the trade reaches its maximum profit potential. Conversely, if the price of the underlying shares rises to the strike price of the long call, the maximum limited loss occurs. Always monitor the underlying shares for a reversal or a breakout to avoid incurring a loss. Exiting the Trade XYZ rises above the long strike (55): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 per share. By exercising the long call, you can turn around and buy those shares at $55 each, thereby losing $500. This loss is mitigated by the initial $250 credit received for a total loss of $250 (not including commissions). XYZ falls below the long strike (55), but not below the breakeven (52.50): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 a share by purchasing XYZ at the current price. This loss is mitigated by the initial $250 credit received. You can also sell the 55 call to offset and further reduce the loss. XYZ falls below the breakeven (52.50), but not as low as the short strike (50): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 a share by purchasing XYZ at the current price. The loss is offset by the initial $250 credit received. Selling the 55 call can bring in some additional money to offset the loss. XYZ falls below the short strike (50): Let the options expire worthless to make the maximum profit of $250. Bear Call Spread Case Study A bear call spread is a credit strategy that benefits from the underlying security trading sideways or lower. Stocks often run into resistance, which impedes higher movement. At these times, using an at-the-money credit spread can bring in profits. A credit spread profits if the stock moves in Strategy: Buy a call at a higher strike price. Sell a call at a lower strike price. Both options must have identical expiration dates Market Opportunity: Look for a moderately bearish to bearish market where you expect a decrease in the price of the underlying asset below the strike price of the call option sold. Maximum Risk: Limited. (Difference in strikes - net credit) 100. Maxi mum risk results when the market closes at or above the strike price of the long option. Maximum Profit: Limited to the net credit received. Maximum profit is made when the market closes below the strike price of the short calls. This is a credit trade when initiated. Breakeven: Strike price of lower call + net credit received. Margin: Required. Amount subject to brokers discretion. two of the possible three directions a stock can move. A bear call spread benefits from sideways movement as well as a decline in prices. Lets review: A bear call spread consists of selling a call and buying a lower strike call. The sale of the higher strike call brings in premium that is larger than the amount it costs to buy the lower strike call, thereby creating a limited risk/limited reward strategy. However, unlike a debit spread, the potential loss on a credit spread is almost always higher than the potential profit. However, the odds of success are very high, which is why these strategies are worthy of additional study. On September 23, 2003, shares of Monster Worldwide (MNST) were showing bearish tendencies. The stock closed the session on September 24 at $27.74 and it looked likely that $25 would be broken. During the next session, it was possible to enter a bear call spread for a nice credit. Since a credit spread benefits from time decay, its important to use front month options. By selling the October 25 call for 3.10 and buying the October 30 call for 0.70, this bear call spread would have brought in a credit of $2.40 per contract. The maximum risk would be $2.60 per contract, which is a rather good reward-to-risk ratio for a credit spread. The risk graph for this trade is shown in Figure 5.8. In two out of every three cases, credit spreads expire with the trader keeping the entire credit. This is because traders of bear call spreads profit if the stock stays constant or moves down. For this example, the maximum reward is the credit received, which for five contracts would be $1,200. The maximum risk is found by subtracting the credit per contract from the difference between strikes (30 - 25 = 5). Thus, the maximum risk is $260 per contract [(5 - 2.40) 100 = $260)] or $1,300 for five contracts, and the reward/risk ratio is 0.92 to 1.00. The breakeven is determined by adding the initial credit to the lower strike, or 27.40: (25 + 2.40 = 27.40). So lets take a look at what happened in the real world. Shares of MNST traded near $25 for the next week, but on October 10, they shot sharply higher. However, the upper strike was not penetrated, with the high of the session coming at $29.35. During the next week, shares of MNST fell and on expiration Friday, October 17, the stock traded as low as $25 and the short call could have been purchased back for anywhere from $0.25 to $1.70. In this case, the October 25 call was purchased back for $0.45, leaving a profit of $195 per contract or $975 for all five contracts. Bear Call Spread Case Study Strategy: With the security trading near $27 a share on September 24, 2003, sell 5 October 25 calls @ 3.10 and buy 5 October 30 calls @ 0.70 on Monster Worldwide (MNST). Market Opportunity: Expect a moderate decline in the underlying stock price. Maximum Risk: (Difference in strikes 100) - net credit. In this case, $1,300: 5 {[(30 - 25) 100] - 240} = $1,300. Maximum Profit: Net credit = Short premium - long premium. In this case, $1,200: 5 (3.10 - .70) = $1,200. Breakeven: Lower strike plus the initial credit per contract. In this case, 27.40: (25 + 2.40). |
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