The Bear Call Spread Explained
If you are on the lookout for a strategy that will help you make decent profits and lesser losses while keeping your risk-reward ratio better, then the bear call spread is what you should be considering.
The bear call spread option is an effective strategy that investors can use to profit from a declining market. It is a debit spread where the investor sells a call option with a higher striking price and buys another with a lower striking price.
What is the Bear Call Spread?
A bear call spread is a bearish strategy used when the market's outlook is moderately bearish. This position involves buying a lower strike price call and selling an out of the money call on the same stock and expiry date. This position is profitable when the underlying stock moves down before expiry, and losses occur when the underlying moves up. The maximum profit is realized when the underlying stock price reaches zero, but losses are limited to debit paid for this strategy.
The maximum profit from the position occurs if the underlying security price at expiration is at or below the sold call's strike price. The maximum loss from the position occurs if the underlying security price at expiration is above the bought call's strike price.
A bear call spread is a type of vertical spread. It contains two calls with the same expiration but different strikes. The spread generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rise.
Illustration of Bear Call Spread Through an Example
The maximum possible profit for the Bearish-Bear Call Spread in India is the difference between the strike price of the options minus the premium paid. The maximum possible loss is limited to the premium paid if the stock price is below both strike prices at expiration.
Let's say you have identified a stock that is trading at INR 100 and is convinced that the price will go down. You can make money by employing the Bearish-Bear Call Spread strategy without having to sell short stocks.
You will buy a put option with a strike price of INR 100 to create this strategy and sell another put option with a strike price of INR 90 (both options have the same expiry date).
For example, if you buy a Bull Call Spread on Infosys at INR 8200/8220 at a premium of INR 20/-, you buy one call option at INR 8200 and sell one call option INR 8220. You pay INR 20/- for this strategy as your net premium outflow. Let's see how this strategy will behave under various situations:
Scenario 1: If Infosys expires at INR 8130, your options will expire worthlessly. Your total loss is INR 20/- your net premium outflow. If Infosys expires at INR 8180, your options will again expire worthlessly, but this time you get back some money because of your long call, which gets exercised, and you pay INR 70/- ( INR8180 8020) from the short call that you have sold and lost INR 200 (8220 premium received due to selling the OTM call option.
Detailed Overview of the Steps Taken for the Bear Call Spread
Step 1: Choose the underlying Stock, Index, or ETF you wish to trade. We create a market watch on the underlying spread strategy we want to implement.
Step 2: Decide the strikes you wish to execute the spread. It is essential to check both the Calls' IV (Implied Volatility). The IV of the purchased Call needs to be higher than that of the Sold Call. Go to the option chain of that underlying and find out the contract with the highest open interest (OI) in Call options.
Step 3: The strikes are decided, but now we need to calculate the net debit. This will help us understand what maximum amount we can lose in this strategy if things go against us. In Bearish-Bear Call Spread, our maximum loss is limited to this net debit. Select the two contracts with different strikes. The lower strike contract of those two will serve as our long call. And higher strike contract will serve as our short call.
Step 4: The position is ready, and now we need to execute it by entering a buy order for one call and a sell order for another call with different strike prices. Enter the quantity (multiplier). The minimum amount for derivatives trading is one lot, equal to 75 units per lot. So, you can buy or sell as many lots as you want.
E.g., If you want to trade two lots of Bearish-Bear Call Spread, you need to enter 2 in the quantity field.
Step 5: Once you have entered a position then, there are two ways you can exit from it. One is by squaring off your open positions, and the second is by exercising your options by paying the price difference between two strikes only if it's profitable for you. Click on the "Spread Order" button and place your order.
Advantages of the Bear Call Spread
The following are the advantages of the bear call spread in India:
- The bear call spreads are low risk: The risk is limited to the difference between the strike price of the call options minus the premium received for selling the call option.
- The probability of profit is higher than other bearish strategies because it requires a lower margin.
- Lower margin requirements: The option spread requires less margin than other bearish strategies.
- Limited loss: As per the above point, this strategy has a limited loss equal to the difference between the strike price of the call options minus the premium received for selling the call option.
- This strategy has a high probability of success if the view on the underlying is correct.
- It can be implemented at low capital and also protects against downside risk.
This is one investment strategy that an investor can use to earn money while staying in the same market. If you are trading intending to hold the positions for some time, this would be an ideal strategy as it provides an attractive risk to reward ratio and is also easy to manage.