All you superhero fans out there know that Superman has an evil doppelganger, Bizarro.
This corrupt clone is a mirror image of Superman, with opposite characteristics, strengths, and weaknesses as our hero.
Now last week, I introduced you to the bull put spread, which is the “Superman” of exploiting slighter upward market moves.
Today, we’re going to meet its mirror image.
But it’s far from evil…
And it has a special superpower that even Superman would want when the markets start falling…
Introducing… the Bear Call Spread… and its Power to Capitalize on Smaller Market Downturns
The bear call spread is the mirror image of the bull put spread.
Unlike the bull put spread, the bear call spread’s superpower is tracking and capitalizing on smaller downward market moves.
That’s right… downward market moves.
Now you may be thinking that I’ve really lost my mind this time, but I promise you… I am perfectly fine.
But before we jump into the force of the bear call spread for downward market moves, let’s take a quick look at call options…
A call option gives the buyer the right, but not the obligation, to buy the stock from a seller or the marketplace at a specific price on – or before- expiration.
As an example, say you believe a stock at $100 is poised to go higher. You can buy a call option with at a $100 strike price for $2.00 – or $200- for 1 contract (remember 1 contract = 100 shares). At expiration, the stock is trading at $105, leaving your call option with a value of at least $5.00.
If you were to exercise your right to buy, you would buy at the strike of $100 and have a stock that can now be sold on the open market for $105. This $5 built-in profit potential will be reflected in the premium of the option as its intrinsic value.
It’s at this point in time and price that you could sell the option you originally bought for $200 for $500 and bank a nice profit and percentage return.
Now there’s a CRAZY call options strategy some folks use on a stock that’s expected to go down in price – selling naked calls.
But just as we saw with selling naked put options, selling naked call options is just TOO risky and I will never recommend it.
As with naked puts, selling naked calls means you’re selling something you do not own when you feel a stock is going to drop in price. And this is a very dangerous strategy. But some traders will try this…
Say you believe that the same $100 stock we used in our call example above is due to drop in price to $95 or $92. As a naked call seller, you would go ahead and sell one contract of the $100 call for $2.00 – or $200.And when the stock drops to $92, you would expect the call you sold to be exercised.
This means you would have to sell the stock at $100. And since you DO NOT OWN the stock, you’d have to buy the stock in the open market for whatever the current price is in order to replace it at $100.
This would be ok as long as you buy the stock at $92 and sell it (or replace it) at $100, giving you $8.00 (or $800) on the stock transaction. Add to this the $200 from the sold call option, and this is the type of profit that entices people into selling naked options.
But here’s the truth…
The risk on a naked call is even HIGHER than the risk on a naked put. If you’ll recall, the risk on a naked put is from the stock price down to zero.
But with a naked call, the risk is virtually unlimited.
That’s right – there is unlimited risk potential on naked call options. If you sell a naked call, you are OBLIGATED to deliver the stock at that strike price if called upon to do so.
So that stock you’ll need to buy has the potential to shoot up to $200 – or even more. And when the option gets exercised, you’ll have to buy the stock in the open market at the current price of, say, $200 in order to replace it at $100.
This results in a $100 per share loss – or a $10,000 loss on just one contract. And when this happens, that $200 you received when you sold the call is worthless.
Which leads us to the bear call spread…
Rescue the Rewards from Falling Stock Prices Using the Bear Call Spread
A bear call spread is a “call credit spread” where you sell a call at a certain strike price and buy another call at a higher strike price. The number of contracts for each and the expiration month should be the same for this type of spread.
Rather than using a bearish loophole strategy, the bear call spread will pay out its maximum reward at expiration without a transaction cost – as long as the stock ends up where it should.
Below is an example of selling a $97 call and buying a $100 call, creating a $3 call credit spread.
To highlight what we are looking at in the images below, I’ve numbered them as follows:
- The sale of the lower strike call and the purchase of the next higher strike call at the same time and as one order.
- The credit amount on a per contract basis as a result
- The maximum profit and risk potential on the trade
Click to View
A long put option may pay out more due to the fact the stock has the opportunity to drop all the way down to zero. But,
by minimizing the risk of buying options and creating a spread, you still – as you can see in this case- have the chance for a healthy return on investment (ROI) percentage.
The risk graph below illustrates the maximum risk and reward potential of this trade.
You face your maximum risk if the transaction gets executed when the stock is anywhere above $100 at expiration. If the stock gets sold at, say $97, and you have to buy it at $100, the difference in the strike prices – $3.00- is your loss. You offset that $3.00 loss with the credit of $2.09 that’s generated to open the position. Therefore, your maximum risk amount is $91 (all on a per contract basis).
Anywhere below $95 at expiration gives you the maximum reward of $209 because if the stock is below $97, who would want to exercise the right to buy it from you at the higher price of $97?
Likely no one.
Therefore, you do not have to exercise your right to buy the stock at $100 in order to replace at it $97. Both options expire, and you keep the premium you sold to open the trade.
There are many similarities between the bull put spread and its mirror image, the bear call spread. In either strategy, you need the stock to be trading out-of-the-money at expiration to maximize your reward potential.
But while the bull put spread needs prices to move slightly higher, the bear call spread only needs prices to slightly drop.
And in today’s market conditions, this makes it a powerful contender.
Your Trading Lesson Summary
STRATEGY: Capitalizing on Smaller Downward Market Moves Using the Bear Call Spread
Last week, we talked about the bull put spread and using it to make money off of slighter upward market moves. Today, we’re going to meet its “mirror image” and learn the power it is has in slightly falling markets. Here are three things to know:
- The bear call spread strategy involves sale of the lower strike call and the purchase of the next higher strike call at the same time and as one order.
- The bear call spread minimizes the cost of long calloptions.
- The probability of a bear call spread trade reaching the maximum profitability point is greater than that of a long put option.