The phrase “call option” makes most investors think of a stock on the rise, which, of course, is almost always correct — but bear-call spreads provide an exception.
As the “bear” part of the name implies, a bear-call spread is a great option strategy to use when you expect that the underlying stock, index or commodity will decline in price.
So how does the “call” work with that?
A bear-call spread works by selling call options at a particular strike price while also purchasing an equal number of calls at a higher strike price as a hedge in the same transaction.
The good news is that this strategy is fairly conservative and you collect premium at the time you make the trade. (This strategy is also called a call credit spread.)
However, because you collect money at the outset of the trade, bear-call spreads cap your profit potential: Your maximum return equals the difference between what you pay for the long option versus what you collect on the short option. (Of course, you want to collect more on the short option than you pay for the long option, which is what makes this a credit spread.)
Essentially, in a bear-call spread, the value of the spread goes up as the stock goes down, and you receive a credit for initiating this trade. You incur a debit for the long position (that you Buy to Open) and receive a credit for the position you write (or Sell to Open), so you pocket the maximum profitability right away. Your goal is to keep the premium upon the spread’s expiration.
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Why would you go with a spread strategy and not outright Sell to Open the lower-strike call for a bigger initial payout? When you buy the call options (or even the stock) to hold long against the short call position, you’re protected in case the trade doesn’t go in your favor. How? Because if someone is long the calls you are short, they can “assign” you to sell stock to them at the short option’s strike price — stock you may not own and must scramble to buy at market price. But the long call cancels out that assignment, because you, as the owner of the higher-strike call, can buy shares at a fixed price and then turn around and sell them at the lower strike to fulfill your obligation.
The first question many investors have about this is, “How can you sell a ‘lower’ strike call on the same stock you don’t own?”
Well, let’s look at an example. Note that this is for illustrative purposes only and not an actual recommendation:
Suppose you think the iPhone is going to clean the clocks of other cell-phone manufacturers. You can establish a bear-call spread in Nokia (NOK).
If you buy the Nokia January 40 Calls for $3 and write (or sell) the Nokia January 35 Calls for $5, you’re collecting a credit of $2 on a bet that the stock will be trading below $35 by the third Friday in January.
If the stock goes up and you’re assigned to provide stock at $35, you can exercise your right as the holder of the $40 calls to buy stock at $40 and turn around and sell it for $35. That’s a $5 loss per share (or $500 per contract), but after you factor in your $2 credit, it’s a $3 loss. (Meanwhile, the investor who bought stock at $40 has lost $5 per share with nothing to offset it.)
By establishing a bear-call spread, at the very least, you would want for the stock to go lower than $37 (the value of the lower strike, which is $35, plus the $2 credit you collected on the spread, or $37) — this is your “breakeven” point. In this case, the call at the $40 strike would likely expire worthless, and if the stock drops below $35, that call would likely expire worthless, too. And in the case of a credit spread, you want the options to expire with no value because that means the money you made on the day you initiated the trade is all yours and you wouldn’t have to pay to close the position.
A bear-call spread is similar in nature to a covered call, in which you sell a call against a long stock position. In the best-case scenario, the stock trades flat or drops, and you keep the premium you collected from the short call. If the stock goes up, you either lose the premium you collected or you get assigned to provide shares at the strike price, which you can cover with your long shares. In fact, it may appeal to you to have your stock “called” away from you, as you can use the money to purchase another company’s shares or get back in on the original stock at a better price.
The bear-call spread is a great tool for betting on the underlying stock price to falter, and the benefit of owning the higher-strike call instead of owning the stock is because it not only costs less, but you are also spared from owning shares of a declining stock.
That is the overall beauty of options — you can let someone else buy the house, but you get to sublet it for substantially less. And with the bear-call spread, your short call essentially allows you to collect rent on another room and enjoy the proceeds throughout the duration of your stay and long after you leave, too!
