Bear Call Spread

Bear Call Spread

The bear call spread is a vertical credit spread. With a vertical credit spread the investor will sell a lower priced strike call option and purchase a farther out of the money call option as insurance to limit risk. The credit received is the premium received for the short call minus the premium paid for the long call. The maximum risk is defined as the distance between the strikes selected minus the net premium received. The bear call spread is used when your forecast for the underlying is neutral to bearish. To obtain the maximum credit we want the underlying to stay below the short call so that both options expire worthless and we collect the credit. Let’s look at an actual example that currently has decent profit potential. On April 27th, 2012, Amazon, AMZN closed at $226.85. If we look at the weekly call options that expire on May 4th, the $230 call will sell for $2.80 and the $235 call can be bought for $1.44. The net credit we’ll receive is $1.36 or $136 per contract. If we set our maximum allowable loss at $5,000 we’d use 13 contracts. The actual maximum loss would be $4,732, the theoretical profit or expected return would be $1,453 and the maximum profit would be $1,768. If AMZN rises to the lower strike at $230 you could close out the position or do some dynamic delta adjusting to control loss. The position could be adjusted by adding some long calls, short puts or buying some AMZN stock or any combination of those.  The chart below shows the profit/loss points for this call spread.

Investors who have long term stock holdings may also want to use a bear call spread to produce income and have potential for upside gain. One of the disadvantages of the popular covered call strategy is that in exchange for the income received from the covered calls, the investor is forced to forgo upside gain. If the underlying fund makes a large upside move, the investor does not participate. With a bear call spread income is produced by selling out of the money calls and purchasing further out of the money calls in the same quantity.  This way in the event that the stock makes a large upside move, the investor will participate and still receive some income. For example if our investor owns 100 shares of ABC at $25, she could sell one $30 call and buy one $35 call for a net credit.  Above $30 the shares would get called away, but she would still own the $35 call.  Therefore, if the stock were to rise above $35 she would still have unlimited profit potential from the remaining long call at the 35 strike.

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About sellacalloption

Author, Radio Show Host and Portfolio manager and chief option strategist for IWC Asset Management.

Posted on April 28, 2012, in Bearish Option Strategies, Neutral Income Strategies and tagged , , . Bookmark the permalink. Leave a comment.

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