Bear Call Ladder Strategy: Tips to Improve Your Share Trading Success

Background

Do not be tricked into believing that the “Bear” in the name of the “Bear Call Ladder” implies this is a bearish strategy. In fact, it is an adaptation of the Call ratio back spread and should only be employed when you are above all else optimistic about a stock or index.

In a Bear Call Ladder, the cost of buying call options is covered by selling an ‘in the money’ call option. It is normally structured to create a ‘net credit’, resulting in a cash flow that is better than that of the call ratio back spread. Although these strategies offer similar payoffs, their risk profiles are slightly different.

– Strategy Notes

The Bear Call Ladder is a 3 leg option strategy, usually setup for a “net credit”, and it involves –

1. Selling 1 ITM call option
2. Buying 1 ATM call option
3. Buying 1 OTM call option

This is the standard Bear Call Ladder, which requires a 1:1:1 combination. To set up this ladder, you must buy one ITM call option, one ATM option and one OTM option for each unit you sell. There are other ratios, such as 2:2:2 or 3:3:3 that can also be used.

One can take the example of Nifty Spot being at 7790 and anticipate a closing price of 8100 by expiration. Such an outlook is bullish, which can be executed via a Bear Call Ladder.

1. Sell 1 ITM Call option
2. Buy 1 ATM Call option
3. Buy 1 OTM Call option

Make sure –

1. The Call options belong to the same expiry
2. Belongs to the same underlying
3. The ratio is maintained

The trade set up looks like this –

1. 7600 CE, one lot short, the premium received for this is Rs.247/-
2. 7800 CE, one lot long, the premium paid for this option is Rs.117/-
3. 7900 CE, one lot long, the premium paid for this option is Rs.70/-
4. The net credit would be 247-117-70 = 60

We can assess how the overall cash flow of the strategies will be affected at different expiry levels by executing the bear call ladder.

It is important to assess the versatility of the strategy payoff by examining it across multiple expiry levels.

Scenario 1 – Market expires at 7600 (below the lower strike price)

We know the intrinsic value of a call option (upon expiry) is –

Max [Spot – Strike, 0]

The 7600 would have an intrinsic value of

Max [7600 – 7600, 0]

= 0

Since we have sold this option, we get to retain the premium received i.e Rs.247/-

Similarly, the intrinsic value of 7800 CE and 7900 CE would both be zero, thus making us forfeit the premiums paid – Rs.117 and Rs.70 respectively.

Net cash flow would Premium Received – Premium paid

= 247 – 117 – 70

= 60

Scenario 2 – Market expires at 7660 (lower strike + net premium received)

The 7600 CE would have an intrinsic value of –

Max [Spot – Strike, 0]

The 7600 would have an intrinsic value of

Max [7660 – 7600, 0]

= 60

Since the 7600 CE is short, we will lose 60 from 247 and retain the balance

= 247 – 60

= 187

The 7800 and 7900 CE would expire worthless, hence we lose the premium paid i.e 117 and 70 respectively.

The total strategy payoff would be –

= 187 – 117 – 70

= 0

Hence at 7660, the strategy would neither make money nor lose money. Hence this is considered a (lower) breakeven point.

Scenario 3 – Market expires at 7700 (between the breakeven point and middle strike i.e 7660 and 7800)

The intrinsic value of 7600 CE would be –

Max [Spot – Strike, 0]

= [7700 – 7600, 0]

= 100

Since, we have sold this option for 247 the net pay off from the option would be

247 – 100

= 147

Considering the 7800 and 7900 CE, we bought them only to face a loss when they expired. The premium paid was 117 and 70 respectively.

Net payoff from the strategy would be –

147 – 117 – 70

= – 40

Scenario 4 – Market expires at 7800 (at the middle strike price)

Pay attention here, as this is where the tragedy strikes!

The 7600 CE has an intrinsic value of Rs. 200, however, we purchased the option at a premium of Rs.247, meaning there is a risk of loss to us of the intrinsic value.

Hence on the 7600 CE, we lose 200 and retain –

247 – 200

= 47/-

Both 7800 CE and 7900 CE expired without any value, so the premium we paid of 117 and 70 respectively was pointless. Therefore, our total payoff was –

47 – 117 – 70

= -140

Scenario 5 – Market expires at 7900 (at the higher strike price)

Pay attention again, tragedy strikes again

The 7600 CE we have written has an intrinsic value of 300, so if we paid a premium of Rs.247, our loss would exceed the amount we put in.

Hence on the 7600 CE, we lose –

247 – 300

= -53

The intrinsic worth of 7800 CE is 100, since we have shelled out a premium of Rs.117, the resultant returns will be –

100 – 117

= – 17

The expiration of 7900 CE with no value would render the premium paid at 70 to be nullified. Ultimately, the strategy payoff would amount to nothing.

-53 – 17 – 70

= -140

Do note, the loss at both 7800 and 7900 is the same.

Scenario 6 – Market expires at 8040 (sum of long strike minus short strike minus net premium)

The bear call ladder is similar to the call ratio back spread in that it has two breakeven points, the lower and upper. We looked at the lower one (scenario 2) earlier, so let’s now look at the upper one: it can be estimated as…

(7900 + 7800) – 7600 – 60

= 15700 – 7600 – 60

= 8100 – 60

= 8040

Take note, we are long on 7900 and 7800 and short on 7600 with a net credit of 60.

So at 8040, all the call options would have an intrinsic value –

7600 CE would have an intrinsic value of 8040 – 7600 = 440, since we are short on this at 247, we stand to lose 247 – 440 = -193.

7800 CE would have an intrinsic value of 8040 – 7800 = 240, since we are long on this at 117, we make 240 – 117 = +123

7900 CE would have an intrinsic value of 8040 – 7900 = 140, since we are long on this at 70, we make 140 – 70 = +70

Hence the total payoff from the Bear Call Ladder would be –

-193 + 123 + 70

= 0

At 8040, the strategy will neither gain nor suffer a loss. This is deemed as the upper breakeven point.

It’s clear that at 7800 and 7900, the strategy was not creating any profit. When it reached 8040, it stopped losing money, indicating that beyond this point, profits could be expected. Let’s investigate further with another situation.

Scenario 7 – Market expires at 8300

At 8300 all the call options would have an intrinsic value.

7600 CE would have an intrinsic value of 8300 – 7600 = 700, since we are short on this at 247, we stand to lose 247 – 700 = -453.

7800 CE would have an intrinsic value of 8300 – 7800 = 500, since we are long on this at 117, we make 500 – 117 = +383

7900 CE would have an intrinsic value of 8300 – 7900 = 400, since we are long on this at 70, we make 400 – 70 = +330

Hence the total payoff from the Bear Call Ladder would be –

-453 + 383 + 330

= 260

The market move directly impacts the potential profits. The following table reveals the expected payouts at various levels.

When the market dips below, you are looking at a moderate gain of 60 points. However, should it ascend, the potential profits are limitless.

– Strategy Generalization

After considering the scenarios that were previously discussed, we can make some generalizations.

• Spread = technically this is a ladder and not really a spread. However the 1st two option legs creates a classic “spread” wherein we sell ITM and buy ATM. Hence the spread could be taken as the difference between the ITM and ITM options. In this case it would be 200 (7800 – 7600)

• Net Credit = Premium Received from ITM CE – Premium paid to ATM & OTM CE

• Max Loss = Spread (difference between the ITM and ITM options) – Net Credit

• Max Loss occurs at = ATM and OTM  Strike

• The payoff when market goes down = Net Credit

• Lower Breakeven = Lower Strike + Net Credit

• Upper Breakeven = Sum of Long strike minus short strike minus net premium

The Bear Call Ladder is a strategy that can achieve huge profits if the market goes past 8040, while still providing some returns even if prices decrease. However, if the markets don’t move at all, this strategy can be quite damaging and it is recommended you only use it when there is an expectation of movement in either direction.

In my opinion, stocks are the optimal choices for executing this strategy when their quarterly results are due.

– Effect of Greeks

The Greeks have a similar impact on this plan as they do with the Call Ratio Back spread, mainly when it comes to volatility. To help jog your memory, here’s a review of our conversation about volatility in the earlier chapter.

There are three colored lines depicting the change of “net premium” aka the strategy payoff versus change in volatility. These lines help us understand the effect of increase in volatility on the strategy keeping time to expiry in perspective.

1. Blue Line – It suggests that if the amount of time left until expiry is substantial (30 days or more), volatility can be advantageous for Bear Call Ladder Spreads. Our strategy’s yield rises from -67 to +43 going from a volatility of 15% up to 30%. We can conclude, then, that when one is expecting an extended period before expiry, it’s important to keep in mind the volatility levels of the market or asset in question. Consequently, even though I’m usually bullish on a given stock or index, I’d hesitate to employ this spread if the volatility was much higher than usual (say double or more).
2. Green line – It is clear that an upturn in volatility closer to expiry can be advantageous, although not as considerably as earlier. As demonstrated, the strategy reward increases from -77 to -47 when the volatility moves from 15% to 30%.

Red line – It’s noteworthy how, in the case of a short time to expiry, increasing volatility can actually be detrimental to the strategy. Indeed, should there be more days remaining until the option’s expiry date and volatility is high, the risk of it ending out-of-the-money (OTM) increases, resulting in a decrease in premiums. As such, if you are bullish on a stock/index with a limited time left, but anticipate further volatility during this period then caution must be exercised.