Bear Call Spreads

Bear Call Spread Strategy Summary

High Level Concept:

1. 
   Choose a stock or symbol that research indicates that it may remain steady & not go up, implying that it is NOT bullish. Or it is okay if it will be going down.
2. 
   Then choose two strike price with a SPREAD of few dollars that is out of the money.
3. 
   Then you SELL a CALL … the lower of the two strike prices.
4. 
   Next, you BUY a CALL … the strike price is higher than what you sold.
5. 
   You pocket the difference in the premium that you receive between the 2 strike prices … for each contract.

Example:

XLE is trading at 86

You choose to SELL a CALL with Strike Price = 90 & get a premium of $1.00
This is a SHORT position

Now, you BUY a CALL with Strike Price = 92 & it costs you a premium of $0.70
This is a LONG position

It is best to have both positions for same expiration month.

You pocket the difference in the premiums of $1.00 - $0.70 = $0.30 (this is the credit per share)
Note: Trading is conducted in contracts, each contract = 100 shares. Also, we will not take into account the commissions for both transactions, which are generally quite low (generally $25 for the entire trade).

If you buy & sell 10 contracts, you get a credit of $0.30x1000 = $300.00.

So in the above example for 10 contracts (1000 shares): Selling CALLs credits $1.00x1000 = $1000.00

Buying CALLs debits $0.70x1000= $700.00

Net Credit = 1000.00 – 700.00 = 300.00

What happens at expiration:

If the stock remains below 90, do nothing, you keep the $300.00

It is recommended that if it reaches very close to 90 or the market is bullish, plus your research indicates that XLE will hit 90 by expiration, then, monitor, & may be close the SHORT position. You do not want to be assigned the stock with a small loss.

Prior to getting into the position, conduct the research & analysis. We do not want or expect it to hit 90 in this case, else do not even enter into such a trade.

Margin, Risk, & Additional Notes:

Margin requirement is the difference between the strike prices times the # of shares.

The maximum profit is the net credit (difference in premiums). $500 in this example.

Maximum risk is the difference between the strike prices, less the net credit (difference in premiums). Here, maximum risk is $2000.

The above is calculated: 1000 shares x 2 spread = $2000 is your investment. Credit received = $300. So the worst case scenario is losing $2000 - $300 = $1700

You therefore receive a round figure 17% return w/o taking into account commissions. Or let us round off to 16% if you account for commissions. This is for duration of 40 - 60 days max. Not bad, if you can repeat & roll such strategy every month.

This is a limited risk & limited income strategy.

Your break-even point is the higher strike price (#1) minus the net credit.

In above example the break-even is at 90.00 + 0.30 = $90.30.

So you are not at a loss as long as the stock price remains below this number.

You choose the right stock + the trend is bearish, as well as "Out Of The Money" (OTM).


A few words on what to choose?

Here, in the example, we chose XLE. That is related to the Oil & Exploration industry, is an ETF. It is safer to choose ETFs or an equity in a strong industry (as in this example). Also, one point to note is that an ETF is not directly dependent on earnings calendar when compared to individual stocks which may get beaten up when earnings are reported. In simple words, choosing ETFs is comparatively safer.

Bottom line, investing in options is not for everyone & there are risks involved.

Options expire, you can lose the entire investment if the stock/ETF goes down substantially or crashes. Research & study details prior to investing in any form.

Do your homework, consult an expert &/or someone who is very familiar with investing in options.

Look into Index Options & E-Minis, especially that are liquid & settle in European style. You do not get assigned if it hits the strike price of the Short position.
Examples include – RUT, SPX, XSP, OEX, VIX, ….