This article originally appeared on The Options Insider Web site.
In the first article of this five-part series on vertical spreads, I introduced the concept of verticals and defined their four main components. Now I am going discuss a specific vertical spread that happens to be one of my favorite strategies.
While it’s known as a bear call, short credit call or vertical call sale, I’ll stick with bear call. First let me break that name down for you. The adjective (bear) modifies the noun (call). A bear call spread is built with call options, yet it is a bearish strategy. The aggregate of the two options’ deltas (sold call and bought call) produces a negatively correlated delta. Whenever the delta is negative, the position’s outlook is bearish by nature.
A short bear call benefits from time decay, hence, it is wise to sell a bear call when the implied volatility (I.V.) is high or at its higher range.
Executing a Bear Call Spread
When placing the actual cear call trade, it is essential that the trader determines where the price will NOT be at expiry. If, for instance, the trend is bearish and an underlying is trading below a major area of resistance, then that resistance could be used for strike price selection.
For instance, if a fictional optionable stock is trading at $49.85 and the $50 zone is acting as a significant level of resistance, then selling the front month 50 call would make perfect sense.
However, prior to the sale of the 50 call, the next higher strike price needs to be purchased; otherwise, the trader would end up with a naked 50 call position. Such a position might require a large maintenance by the brokerage house, or the trade might not even go through if the size of the option trader’s account is not big enough. In that case, the trade would simply get rejected.
On the $50 product the strike prices could be either in dollar increments, or $2.50, or even $5. If the strike price increments are $5 wide, then the trader could first purchase the 55 out-of-the-money (OTM) call, and then proceed with selling the near-the-money 50 call.
The profit and loss graph of the sold 55 call and bought 50 call is represented in Figure 1 below.
When an OTM option is bought, it is worth less than the at-the-money (ATM) option that will later be sold. In other words, the first leg (bought OTM call) will be cheaper than the second leg (sold ATM call).
When the math is done, the cost of the bought call subtracted from the premium received for the sold call will produce a credit; hence the name vertical credit call spread.
Whenever the seller of a bear call ends up receiving some money, it is called a net credit spread. Personally, I prefer to be a net premium seller.
The goal of a bear call is to keep as much of the net credit as possible. Let me emphasize the words, “as much as possible.” Many times, novice option traders aim at having the maximum profit and not paying any extra commission, yet it could easily happen that the underlying issue could rally on the day of expiry and ruin their perfect plan.
Hence, I suggest keeping greed in check and not aiming at getting the maximum profit but just a majority of it.
By selling an ATM call, the delta is usually 50, which means that the buyer of the call has a 50% chance of winning. If we, as the seller, were accurate with our technical analysis, and the product moves lower, then the delta changes with the downward move.
In conclusion, the sole purpose of this article was to explain the vertical credit call and emphasize the point that the selling of it should be done when the implied volatility of the underlying is at its 52-week high, or at least in the higher range. If the majority of the underlyings that you are trading are sitting at their lows, then selling credit spreads isn’t the most profitable solution.
In the next article in this series, I will focus on the vertical debit call, which should be done when the implied volatility is at its low.
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