Options Strategies for a Bear Market - Part 2
by C. Talmadge BellMay 31, 2012 | Comments : 0 Recommended this article: (0)
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In a previous article I discussed the Bear Put Spread. This article will discuss a similar option strategy that is called a Bear Call Spread. They both are strategies for profiting in a downward trending market. One major difference from the Bear Put Spread is that a Bear Call Spread is a credit spread. This means instead of paying a premium for the trade, you receive the premium.
The profitability of a Bear Call Spread depends on how much of the received premium can be kept before the trade expires or is closed. This trade performs best if the underlying stock stays flat or declines in price by the expiration date. Like the Bear Put Spread, the maximum loss is limited. This is accomplished by a protective tradeoff that limits the maximum profit.
What is a Bear Call Spread?
The Bear Call Spread will result in the initial receipt of a premium from the trade. The Bear Put Spread, which was discussed earlier, requires an initial payment of a premium for the trade. However, the Bear Call Spread may require paying back part, or all, of the premium received initially.
It is constructed by buying a Call with a strike price that is usually out of the money and selling a Call with a strike price that is lower than the long position and usually in the money. Both Calls have the same expiration date. The premium received from the short Call (lower strike price) will be greater than the premium that is paid for the longer Call (higher strike price). Thus, you will always start out with your maximum profit already in your account.
As an example, I am analyzing US Steel ( X - Analyst Report ) which is trading at $22.45. If my analysis indicates that the price of the stock could continue to stay flat or decline, I can trade a Bear Call Spread by buying the $23.00 Jun Call for $0.77 and selling the $21.00 Jun Call for $1.96, receiving an income of $1.19 per share. The calculations for one contract are:
The $21.00 Call was sold because I believe the stock price will decline. The $23.00 Call was bought to limit the risk from possible assignment if the stock price rises above the short position at the time of expiration.
The maximum gain on a Bear Call Spread is the net premium received at the initiation of the trade. The best case scenario is that the stock's price declines to the $21.00 strike price of the short Call (or lower) at the expiration date. In this case, both Calls will expire worthless and you retain the entire premium that was initially received.
Of course, you do not have to wait until the expiration date to close the position. At any time that a good portion of the received premium can be retained, one can close the position for the net cost of both Calls and keep the difference. This might be done so as to not risk the stock price reversing and potentially losing a part of the gain that was already attained.
The maximum loss is limited to a specific amount that is known at the time the trade is initiated. It occurs when the stock price is above the long Call at expiration in the example, the $23.00 Call. At that time, you would be assigned the short call, but you will then exercise the long Call. The maximum loss will be the difference between the two strike prices, but reduced by the net premium that was initially received:
Of course, one does not have to wait until expiration and incur this entire loss. At any time prior to expiration, if it appears that the trade will not produce a gain, it can be closed out. A savvy investor would not allow a losing trade to go to expiration. At any point between the time that the trade was initiated and the expiration date, the trade could be closed out with a loss of less than the maximum loss of $81.00 per contract.
The breakeven point occurs if the stock price is above the lower strike price by the amount of the net premium received. In the example, this would be $22.19 ($21.00 + $1.19). In other words, this trade begins to be profitable when the underlying stock price is lower than $22.10.
The potential return on a Bear Call Spread will be significantly impacted by the trader's choice of the two strike prices.
Additional Factors to Consider
If the underlying stock is close to the strike price at expiration, one cannot know for sure if the short position will be assigned until the following Monday. So, either close out the trade early or be prepared for the Monday assignment.
Early assignment is possible, but generally only when the options are deeply in the money or if the stock's ex-dividend date occurs before or on the expiration date. If an assignment occurs, your broker will usually require you to finance the long position for one day.
The effects of decay with a short position and a long position may partially offset each other. However, since this is a net credit trade, it is most likely that the time decay will benefit the trade.
The use of a Bear Call Spread provides a trade that has a limited risk with a limited reward. It is produced by buying a Call and selling another Call at a lower strike price. This strategy will be profitable if the stock price remains flat or declines.
The maximum profit is the net premium that is received at the initiation of the trade. If the stock price increases instead of declining, the maximum loss is limited by the long call.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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