From the February 2014 issue of Futures Magazine • Subscribe!

A bear call spread offers several ways to profit

Question:

Is there a time and a trade when it is beneficial for a position to take on more risk than the potential reward?

Answer:

When a stock is overbought or is facing possible resistance, a bear call spread offers several ways to profit.

With the market appearing to be somewhat extended to the upside, it might be a good opportunity to discuss a non-bullish strategy — one that can put the odds on your side, but with limited gains. Here is a breakdown of a call credit spread and its possible uses.

Bear Call: A bear call spread might be viewed as a high-risk and low-reward trade. Why would an option trader do this? Because it usually comes with a high probability of success when compared to a debit spread, such as the bear put spread.

Many new option traders tend to stay away from credit spreads because they usually risk more than they can make, especially when the spread is set up out-of-the-money (OTM). Debit spreads are preferred and easier to understand. But a trader needs to dig deeper and see that there are other benefits to a credit spread that might influence his or her decision.

One of the advantages of a credit spread is that it still can profit even if the stock moves slightly against your position. Basically, it has really three out of four ways of making money if the spread is implemented OTM. A debit spread, such as a bear put spread, usually needs the underlying to fall to profit from the spread.

A bear call spread involves selling a call while purchasing a higher strike call with the same expiration. The short call is more expensive than the long call. Adding a long call to the short call position creates a credit spread and protects the position from further losses if the underlying rallies past the two strikes. The maximum profit is the original premium received from the spread if the stock finishes below the short strike at expiration; the spread would expire worthless. The maximum loss occurs if the stock finishes above the long call at expiration. This credit spread has a smaller potential profit than a naked call option, but also limits risk. 

Because premium is being sold in this spread, the trade benefits from the passage of time. Theta measures the rate of decline in the value of an option because of the passage of time. The closer the options are to expiration, the more the theta decreases the premium of the spread. However, the more time there is until expiration, the bigger the initial spread premium will be. It is a trade-off of premium vs. time and usually these credit spreads are set up anywhere from one day to two months until expiration. In addition, the closer the spread is set up to the current price, the greater the premium will be and vice-versa. 

Here’s an example:

Apple Inc. (AAPL) is trading near $540 on Jan. 7 after trading just above $570 a couple of weeks earlier. An options trader sees that the stock has a pivot at $560 from previous price action, which will serve as resistance. He may try to capitalize from this forecast by implementing a bear call spread.

The trader sells a call at or slightly above the potential resistance level and buys a higher-strike call for protection. 

With a bear call spread, choosing strikes that are farther away from the current price with the same strike distance usually means the less the credit that will be received on the spread. For example, if the current stock price is $540, a 560/565 bear call spread should generate a larger credit than a 565/570 bear call spread. The credit received is the maximum profit that can be attained. So with a bear call spread, there exists a natural trade-off of chances of success vs. payout structure. The higher the short strike, the safer; the lower, the greater profit potential. The trader decides to sell the lower strike spread, which gives the trade a potential greater reward.

In the above example, a trader can sell a 560/565 January bear call spread with 11 days to expiration for a 60¢ credit:

 

560 call collects $2.15 premium; 565 call costs $1.55 = 60¢ premium collected 

 

If AAPL finishes under $560 by January expiration, the spread would expire worthless and the trader would keep the credit. The maximum at risk on the trade is the difference in the strike prices minus the credit received: 

 

$560 – $565 = –$5 + 60¢ premium = –$4.40

 

The maximum loss would be realized if AAPL were trading above $565 at January expiration. The breakeven point is $560.60 (560 + .60), which is derived from adding the credit to the short call.

The pros and cons of every option strategy regardless of the outlook need to be debated before implementation. There are other factors involved, like the implied volatility of the options. If the implied options volatilities are elevated, the better the chance that there is more premium to sell, which can be advantageous for a credit spread. Bear call spreads may offer lower profit potential, but there are times they are the right play.

John Kmiecik is an options coach for Market Taker Mentoring Inc. E-mail him at john@markettaker.com.

About the Author

John Kmiecik has worked for several firms, including Goldman Sachs and First Options of Chicago, and has traded professionally for hedge funds. Currently, he is an options coach for Market Taker Mentoring LLC. E-mail him at john@markettaker.com.

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