Introduction

You have been researching a stock and have formed a bearish opinion on its value, forecasting that it will decline in price over the coming months. You would like to limit your risk and generate income to establish this position.

Building on your foundational knowledge of call and put options as well as the risks and benefits of single-leg options trades (buy call, sell call, buy put, sell put), you recognize that a two-leg trade, or spread trade, achieves the objectives you have outlined.

Specifically, selling a call expresses your bearish sentiment and achieves the goal of generating income, though your downside gains are capped. By purchasing a higher strike call, you limit the upside risk exposure of the short call.

The combination of a long call and short call is referred to as a spread trade. Risks and benefits of each individual option component, or leg, offset each other to a degree in order to create the desired position and range of possible outcomes.

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What is a Bear Call Spread?

A bear call spread consists of one short call with a lower strike price and one long call with a higher strike price:

• Short 1 XYZ 100 call
• Long 1 XYZ 105 call

Both calls have the same underlying stock and the same expiration date.

A bear call spread is established for a net credit (or net amount received) and profits from a declining stock price.

Both maximum profit and maximum risk (loss) are limited and known.

Worth noting: The “bear call spread” strategy is also known as a “short call spread” and as a “credit call spread.” The term “bear” refers to the fact that the strategy profits with bearish, or falling, stock prices. The term “short” refers to the fact that this strategy is “short the market,” which is another way of saying that it profits from falling prices. Finally, the term “credit” refers to the fact that the strategy is created for a net credit, or net amount received.

Example

• Short 1 XYZ 100 call at $3.30
• Long 1 XYZ 105 call for $1.50

In our example, assume stock XYZ is currently trading around $100.

We sell 1 XYZ 100 call for a total of $330 (1 x 100 multiplier x $3.30) and buy 1 XYZ 105 call for a total of $150 (1 x 100 multiplier x $1.50).

In this example the bear call spread (long call + short call) positions were established for a net credit of $180 ($330 - $150 = $180).

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Outcome 1: Profit

With a bear call spread position, potential profit is limited because of the short call.

First, let’s recall the formulas for individual options positions:

Call Options:

If S – K > 0,

Long Call Profit = Current Stock Price – Strike Price – Net Premium Paid

Short Call Loss = – (Current Stock Price – Strike Price – Net Premium Received)

If S – K < 0,

Short Call Profit = Net Premium Received

Long Call Loss = Net Premium Paid

To calculate our profit on the position we established, we use the formula:

Profit = Profit/Loss on Long Call + Profit/Loss on Short Call

The maximum profit of the bear call spread is limited to the net premium received less transactions, fees, and commissions. This maximum profit is realized if the stock price is at or below the strike price of the short call (lower strike).

Example

Stock XYZ is trading at $100 and you establish a bear call spread for a $1.80 credit.

• Short 1 XYZ 100 call for $3.30
• Long 1 XYZ 105 call at $1.50

A week later, stock XYZ is trading lower at $96.

*Unrealized profits are those that potentially exist; realized profits occur when you close out or trade out of the position.

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Outcome 2: Loss

Let’s assume we are incorrect in our sentiment, and the stock price rises. To calculate our loss on the position, use the following formula:

Loss = Profit/Loss Long Call + Profit/Loss Short Call

Maximum loss is equal to the difference between the strikes less net premium received. This maximum loss scenario occurs if the stock price is at or above the strike price of the long call (higher strike) at expiration.

In our example:

Max Loss = Difference between the strikes – net premium received

= $105 – $100 – $1.80 (not including transaction costs and fees)

= $3.20 per share or $320 total loss

Example

Stock XYZ experiences unexpected news and is now trading higher at $106.

*Unrealized profits are those that potentially exist; realized profits occur when you close out or trade out of the position.

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Outcome 3: Breakeven

The breakeven price calculated on a per share basis for a bear call spread is equal to the short call (lower strike) plus the net premium received.

Breakeven Price = Short Call Strike + Net Premium Received

Example

• Short 1 XYZ 100 put for $3.30
• Long 1 XYZ 105 put at $1.50

Breakeven Price = $100 + $1.80 = $101.80

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At-A-Glance

Strategy

• Bear Call Spread

Alternative Name

• Credit Call Spread

Pre-Requisite Strategy Knowledge

• Long Call
• Short Call

Legs of Trade

• 2 legs

Sentiment

• Bearish

Example

• Short 1 XYZ 100 call
• Long 1 XYZ 105 call

Rule to Remember

• Short call strike must be lower than long call strike, expirations must be the same.

Max Potential Profit (GAIN)

• Limited: Net Premium Received

Break-Even Point

• Lower short call strike + net premium received

Max Potential Risk (LOSS)

• Limited: Difference between the strikes – net premium received

Ideal Outcome

• XYZ price rises to or below the lower short call strike

Margin Requirement

• Yes

Early Assignment Risk

Early assignment risk applies to short options positions only.

America options can be exercised on any business day, and the holder of a short stock options position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment must be considered when entering positions involving short options. Early assignment of stock options is generally related to dividends.

The long call (higher strike) in a bear call spread has no risk of early assignment.

The short call (lower strike) does have such risk.

If the stock price is above the strike price of the short call in a bear call spread (the lower strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. The entire spread can be closed, which involves buying the short call to close and selling the long call to close. Alternatively, the short call can be purchased to close and the long call open can be kept open.

If early assignment of a short call does occur, the obligation to deliver stock can be met either by buying stock in the marketplace or by exercising the long call. Note, however, that whichever method is chosen, the date of stock acquisition will be one day later than the date of the stock sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the stock position created by the option assignment.

Potential Position Created at Expiration

There are three possible outcomes at expiration: the stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price, or above the higher strike price:

• If the stock price is at or below the lower strike price, then both calls in a bear call spread expire worthless and no stock position is created.
• If the stock price is above the lower strike price but not above the higher strike price, then the short call is assigned and a short stock position is created.
• If the stock price is above the higher strike price, then the short call is assigned and the long call is exercised. The stock is then sold at the lower strike price and purchased at the higher strike price, resulting in no stock position.

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