A bear market call option spread is a two-part option strategy that involves selling call options and charging a prepaid option fee, and then simultaneously buying a second call option with the same expiration date but a higher strike price. The bear market call option spread is one of the four basic vertical option spreads.
Because the strike price of the sold call option (ie short call leg) is lower than the strike price of the purchased call option (ie long call leg), the option fee charged on the first side is always greater than on the second leg.
Since the initiation of the power gap in the bear market call period will result in the receipt of a prepaid premium, it is also known as the power gap in the credit call period, or also known as the power gap in the short call period. This strategy is usually used to generate premium income based on option traders’ bearish views on stocks, indices or other financial instruments.
Which vertical option spread should you use?
Profit from bullish spreads in the bear market
The bear market call option spread is somewhat similar to the risk mitigation strategy of buying call options to protect short positions in stocks or indexes. However, because the tool for short selling in a bear market is call options rather than stocks, the maximum return is limited to the net premium received, while in short sales, the maximum profit is that the short selling is affected and is zero (the stock can fall To the theoretical low point).
Therefore, bear market call option spreads should be considered in the following trading situations:
- Expect a mild downturn: This strategy is ideal when traders expect a moderate decline in stocks or indexes rather than sharp declines. why? Because if a sharp decline is expected, traders are best to implement strategies such as short selling, buying put options, or initiating bear market put spreads. The potential benefits of these strategies are large and not limited to the premium received.
- High volatility: High implied volatility translates into higher levels of premium income. Therefore, even if the short side and long side of the bear market call option spread offset the impact of volatility to a considerable extent, when the volatility is high, the strategy’s returns will be better.
- Need to reduce risk: The bear market call option spread limits the theoretically unlimited (that is, uncovered) unlimited losses that may be caused by the short sale of call options. Remember, selling a call option imposes an obligation on the seller to deliver the underlying security at the strike price. Think about the potential loss if the underlying soars two or three times or ten times before the call expires. Therefore, although the long position in the bear market call option spread reduces the net premium that the call option seller (or seller) can earn, the substantial reduction in its cost fully justifies its cost.
Example of a bear market call option spread
Take the hypothetical stock Skyhigh Inc. as an example. The company claims to have invented a revolutionary jet fuel additive that recently hit a record high of $200 in volatile trading. The legendary options trader “Bob Bear” is bearish on the stock. Although he believes that the stock will bottom out at some point, he believes that the stock will only go lower initially. Bob wants to use Skyhigh’s volatility to earn premium income, but is worried that the risk of stock soaring is higher. Therefore, Bob initiated a bear market call spread on Skyhigh as follows:
- Sold 5 US$200 Skyhigh call option contracts, which expire one month later, at a transaction price of US$17.
- Purchase five Skyhigh call option contracts for $210, which also expire within one month, at a transaction price of $12.
- Because each option contract represents 100 shares, Bob’s net premium income is US$2,500, or ($17 x 100 x 5) – ($12 x 100 x 5) = $2,500
For simplicity, we have excluded commissions in these examples. Consider the possible situation one month from now, in the last few minutes of trading on the option expiration date:
Bob’s view proved to be correct, and Skyhigh’s transaction price was $195. In this case, both the $200 and $210 call options have no money and will be worthless at expiration. Therefore, Bob can retain the entire net premium of $2,500 (minus commissions). The situation where the stock is lower than the strike price of the short call option is the best choice for a bear market call spread.
Skyhigh’s transaction price is $205. In this case, the $200 call option is $5 (trading price is $5), and the $210 call option is short of money and therefore worthless.
Therefore, Bob has two options: (A) close the short call leg with $5, or (B) buy stocks on the market for $205 to fulfill the obligations arising from the exercise of the short call option. Option A is preferable because Option B will generate additional commissions for the purchase and delivery of stocks.
Closing a short bullish leg at $5 will require an outlay of $2,500 (ie $5 x 5 contracts x 100 shares per contract). Because Bob received a net credit of $2,500 at the beginning of the bear market call option spread, the total return is $0. Therefore, Bob breaks even in the transaction, but pays out of his own pocket within the commission paid.
Skyhigh’s jet fuel claim has been verified, and the stock is currently trading at $300. In this case, a $200 call option is $100, and a $210 call option is $90.
However, since Bob has a short position in the $200 call option and a long position in the $210 call option, his net loss on the put option spread is: [($100 – $90) x 5 x 100] = 5,000 USD.
But because Bob received $2,500 when the call option spread in the bear market started, the net loss = $2,500-$5,000 =-$2,500 (plus commission).
How does this reduce the risk? In this case, if Bob sells 5 call options for $200 (and does not buy call options for $210) instead of a bear market call option spread, then when Skyhigh trades at $300, his loss will be Yes: 100 USD x 5 x 100 = 50,000 USD.
If Bob shorted 500 shares of Skyhigh for $200 without buying any risk-reducing call options, he would suffer a similar loss.
Bear market call option spread calculation
To recap, these are the key calculations related to bear market call option spreads:
Maximum loss = The difference between the exercise price of the call option (ie the exercise price of the call option less Short call option strike price)-net premium or credit received + commission paid.
Maximum gain = Net premium or credit received – commission paid.
The maximum loss occurs when the stock’s trading price is equal to or higher than the call option’s strike price. Conversely, when the trading price of the stock is equal to or lower than the strike price of the short call option, the maximum return will appear.
break even = Strike price of short call option + net premium or credit received.
In the previous example, the break-even point is = $200 + $5 = $205.
Bear market bullish spread advantage
- The bear market call option spread allows you to earn premium income with a lower risk, instead of selling or writing short call options.
- The bullish spread in the bear market takes advantage of time decay, which is a very effective factor in options strategies. Since most options either expire or are not exercised, the odds are biased towards the originator of the bear market call option spread.
- The bear market spread can be tailored to a person’s risk profile. A relatively conservative trader may choose a narrow spread that is not much different from the bullish execution price, because this will reduce the maximum risk and maximum potential return of the position. Aggressive traders may prefer larger spreads to maximize returns, even if it means greater losses if stocks soar.
- Since it is a spread strategy, compared with selling naked call options, bear market call option spreads have lower margin requirements.
Bear market bullish spread disadvantage
- The benefits of this option strategy are very limited. If the strategy does not work, it may not be enough to justify the risk of loss.
- Short-term call options before expiration have significant transfer risks, especially when stocks are rising rapidly. This may result in traders being forced to buy stocks on the market at a price much higher than the strike price of the short call option, resulting in substantial losses immediately. This risk is even greater if the difference between the strike price of a short call option and a long call option is large.
- The bear market call option spread is most suitable for stocks or indexes with higher volatility and lower trading possibilities, which means that the range of optimal conditions for this strategy is limited.
The bear market call option spread is a suitable option strategy to generate premium income during periods of volatility. However, given that the risks of this strategy outweigh the benefits, its use should be limited to relatively mature investors and traders.