August 4th, 2008Understanding the bear call credit spread
Directional options can work great in directional markets, but in volatile and inconsistent times (Hint: 2008), it helps to spread your bets. There are many option spread strategies; this article will focus on the bear call credit spread.
Before digging into option spreads, it helps to have a good understanding of directional options. Here are a few links to get you started, and a book recommendation for a thorough explanation:
- Getting started with stock options
- Time for cover – the covered call
- Option price modelling – Black Scholes and Excel
The Options Course Second Edition: High Profit & Low Stress Trading Methods (Wiley Trading) by George A. Fontanills
We will use the stock of Apple as a reference only to describe the bear call credit spread. It is NOT a a recommendation!
Let’s look at an August expiration bear call spread on Apple. Today is August 6th, and August options for AAPL expire on the 3rd Friday, or August 17th. Apple stock currently trades near the $153.23 mark. With an August BEAR credit spread on AAPL, it is not necessary to know exactly where Apple will trade on August expiration day. It is only necessary to predict a reasonable threshold mark in which it will trade under. Choosing a 160 upper threshold would carry more risk but result in a higher profit potential then a 170 or 180 upper threshold. The implementation of a bear credit spread involves two simultaneous call option positions:
- A short call at the upper price threshold you determine (i.e. 160, 165, 170, 180 or other)
- A long call at a strike price ABOVE the upper threshold you determine – used as insurance
As an example, consider an August upper threshold prediction of 165 for Apple. That prediction means that you don’t know where Apple will trade on August expiration (August 17th), but you are reasonably confident that it will not be above 165 (currently $153.23). With 11 days until August expiration, here is what the option chain looks like:
By selling 1 contract of the Apple August 165 call for .91, you would collect a credit of $91. In the ideal case, Apple stock would be less then $165 at August expiration, and the option you sold would expire worthless. Your profit would be the $91 credit you collected to initiate the short option position. But this scenario carries significant risk due to the fact that Apple could very well rise above 165. In fact, it is an UNLIMITED risk because Apple stock could theoretically rise to infinity, and wiping out your entire account in the process. That’s where the option spread comes into play. To hedge your risk on the 165 call option you sell, you would also buy a 170 call option on Apple. That strategy is called a BEAR CALL SPREAD, and in our example, is the combination of two call options:
- Selling a 165 August call option on Apple for .91, or $91 per contract
- Buying a 170 August call option on Apple for .40 or $41 per contract
The result is a net credit of $51 for the 165-170 bear call spread, if it were executed based on today’s option chain as shown above. If the Apple closing price at August expiration is less then 165, then both options expire worthless, and your profit is the original $51 credit you previously collected. If the Apple closing price at August expiration is greater then 165, then you could lose money.
Maximum Loss: The maximum loss would occur when Apple closes above the higher strike in the bear call credit spread. Assume for a moment that Apple closes at 185 on August expiration, and dissect the two options:
- 165 call that you sold for .91 would have a value of $20 (185 – 165)
- 170 call that you bought for .40 would have a value of $15 (185-170)
Since both options have value, you would need to close them out. You would have to buy to close the 165 for $2,000, and sell to close the 170 for $1,500. That would give you a loss of $500, but since you had previously collected a $51 credit for opening the credit spread, your actual loss on the entire transaction is only $449 ($500 – $51).
Maximum gain: As you see above, the maximum gain occurs when both options expire worthless, and the maximum loss occurs when Apple closes above the long call strike (170 in the example). The maximum gain percentage is the maximum gain divided by the size of the spread, or $51 divided by $500, or 10.2% not counting commissions. That’s not a bad return for a short trade of a few weeks, but keep in mind that the 10.2% gain comes with a potential risk of a 89.8% loss.
Leverage: The above example assumes one option spread involving a single short call and a single long call. For additional leverage, and to reduce the impact of commissions, the same trade could be performed with multiple short calls and multiple long calls. Keep in mind, however, that as you increase the potential profit of the trade, you are also significantly increasing the potential loss.
On the surface, the bear call option spread is very simple. But before trading them, you will need a lot more knowledge on the proper use of them, the pricing of options, the risks associated with them, and potential adjustments of losing trades into winning trades. Jumping into bear call spreads based on a single article is a sure way to lose a lot of money. I recommend the following book for additional details on option spreads, and more importantly, how to adjust the losing trades into winning trades. Also be sure to check out the geldpress bookstore for more great trading books.
The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour
- Modeling theta time decay in a bear call credit spread
- The volatility clue to the market
- Time for cover – the covered call
- Covered Call Writers Love High Volatility
- Covered Calls – Scottrade, Tradeking, Fidelity
Disclaimer: Option trading is dangerous and you can lose a lot of money. There are no guarantees to the accuracy of any content above, or any content at geldpress. Trade at your own risk!