Bear Call Spread Why Calls can be a Better Choice than Puts

Choosing Calls over Puts

The Bear Call Spread is a two-leg option strategy, which is implemented when the market outlook is ‘moderately bearish’. Unlike a Bear Put Spread, it requires call options instead of put options. The payoff structure for both strategies is similar; however, there are slight variations in terms of strategy implementation and strike selection.

At this point, you might be wondering – why should one opt for a Bear Call spread instead of a Bear Put spread, when their respective payoffs are virtually the same?

This really depends upon how lucrative the premiums are. Executing a Bear Put spread incurs a debit, while the Bear Call spread is a credit; when at a point in the market where –

1. The markets have rallied considerably (therefore CALL premiums have swelled)
2. The volatility is favourable
3. Ample time to expiry

If you’re moderately bearish in the future, then a Bear Call Spread for a net credit may be more appropriate than a Bear Put Spread for a net debit. I tend to favor strategies that result in net credits.

– Strategy Notes

The Bear Call Spread is a two leg spread strategy typically using both In-the-Money and Out-of-the-Money Call options, though other strikes can also be used. The greater the difference between the chosen strikes of the spread, the more profit potential there is.

To implement the bear call spread –

1. Buy 1 OTM Call option (leg 1)
2. Sell 1 ITM Call option (leg 2)

Ensure –

1. All strikes belong to the same underlying
2. Belong to the same expiry series
3. Each leg involves the same number of options

Let us take up example to understand this better –

Date – February 2016

Outlook – Moderately bearish

Nifty Spot – 7222

Bear Call Spread, trade set up –

1. Buy 7400 CE by paying Rs.38/- as premium; do note this is an OTM option. Since money is going out of my account this is a debit transaction
2. Sell 7100 CE and receive Rs.136/- as premium, do note this is an ITM option. Since I receive money, this is a credit transaction
3. The net cash flow is the difference between the debit and credit i.e 136 – 38 = +98, since this is a positive cashflow, there is a net credit to my account.

Generally speaking, in a bear call spread, which is often referred to as a ‘credit spread’, there is usually a ‘net credit’. When we initiate the trade, the market can move in any direction and expire at any level, so let us explore a few scenarios to get an idea of what could happen with the bear put spread for various expiry levels.

Scenario 1 – Market expires at 7500 (above the long Call)

At 7500, both the Call options would have an intrinsic value and hence they both would expire in the money.

• 7400 CE would have an intrinsic value of 100, since we have paid a premium of Rs.38, we would be in a profit of 100 – 38 = 62

• 7100 CE would have an intrinsic value of 400, since we have sold this option at Ra.136, we would incur a loss of 400 – 136 = -264

• Net loss would be -264 + 62 = – 202

Scenario 2 – Market expires at 7400 (at the long call)

At 7400, the 7100 CE would have an intrinsic value and hence would expire in the money. The 7400 CE would expire worthless.

• 7400 CE would expire worthless, hence the entire premium of Rs.38 would be written of as a loss.

• 7100 CE would have an intrinsic value of 300, since we have sold this option at Ra.136, we would incur a loss of 300 – 136 = -164

• Net loss would be -164 -38 = – 202

Do note, the loss at 7400 is similar to the loss at 7500 pointing to the fact that above a certain point loss is capped to 202.

Scenario 3 – Market expires at 7198 (breakeven)

At 7198, the trade neither makes money or losses money, hence this is considered a breakeven point. Let us see how the numbers play out here –

• At 7198, the 7100CE would expire with an intrinsic value of 98. Since we have sold the option at Rs.136, we get to retain a portion of the premium i.e 136 – 98 = +38

• 7400 CE would expire worthless, hence we will lose the premium paid i.e 38

• Net payoff would -38 + 38 = 0

This clearly indicates that the strategy neither makes money or losses money at 7198.

Scenario 4 – Market expires at 7100 (at the short call)

At 7100, both the Call options would expire worthless, hence it would be out of the money.

• 7400 would not have any value, hence the premium paid would be a complete loss, i.e Rs.38

• 7100 will also not have any intrinsic value, hence the entire premium received i.e Rs.136 would be retained back

• Net profit would be 136 – 38 = 98

Clearly, as and when the market falls, the strategy makes a profit.

Scenario 5 – Market expires at 7000 (below the short call)

This scenario tests the strategy’s profitability with an additional dip in the market. Set at 7000, both call options will become useless. We recognize the premium paid for 7400 CE (i.e Rs 38) as a loss, but we get to pocket the entire premium of 7100 CE (Rs 136) as profit. So, overall, the technique gives us Rs 98 in profit. It is evident that when the market plunges, this strategy has the capacity to generate revenue; however, its profits are limited to Rs 98.

As you can see, the outcome is akin to a bear put spread, with pre-determined gains in optimal conditions and losses under unfavorable ones.

– Strategy Generalization

From the evidence presented, we can conclude that there are certain key points that will act as a catalyst for this strategy.

• Spread = Difference between the strikes

• 7400 – 7100 = 300

• Net Credit = Premium Received – Premium Paid

• 136 – 38 = 98

• Breakeven = Lower strike + Net Credit

• 7100 + 98 = 7198

• Max Profit = Net Credit

• Max Loss = Spread – Net Credit

• 300 – 98 = 202

At this stage, we can add up the Deltas to get the overall position delta to know the strategy’s sensitivity to the directional movement.

From the BS calculator I got the Delta values as follows –

• 7400 CE is OTM option and has a delta of +0.32

• 7100 CE is ITM option and has a delta of +0.89

• Since we are short 7100 CE, the delta is – (+0.89) = -0.89

• Overall position delta is = +0.32 + (-0.89) = -0.57

The delta of the strategy is negative, and it indicates that the strategy makes money when the underlying goes down, and makes a loss when the underlying goes up.

– Strike Selection and impact of Volatility

These graphs and summary table will give us an insight into the best call option strikes to pick, based on the time left before expiry. We have already discussed the split up of time frames (1st and 2nd half of the series); thus, I will simply post these resources here.

Strikes to select when we are in the 1st half of the series –

– Strike Selection and impact of Volatility

The following images provide us with the information we need to identify the best call option strikes to choose, bearing in mind the time until expiry. We have discussed the splitting of time frame (first and second half of the series) previously, so I will leave this at posting graphs and a summary table here.

Strikes to select when we are in the 1st half of the series –

It is clear when there is a large amount of time until expiry, one need not be overly concerned with the shifts in volatility. However, keeping an eye on it over the course of the series is advised. When attempting a bear call spread, it should only be done when expecting an increase in volatility; if you expect the opposite trend, this may not be the best strategy.