Bear Call Spread

Ooh...fancy derivatives trade. Get your nerd glasses and the masking tape. Be sure you use this one to amaze and amuse your friends at parties. Then get new friends.

Ok, so in a bear call spread trade, you're buying one call. Remember: that means it's a bet that the stock goes up, or outperforms expectations at that time. And you're selling, or putting, or writing, one call.

Both calls expire on the same date. The difference is that the strike price of the sold call is below the strike of the long call.

Example.

You want to create a Bear Call Spread on DIS, because you think investors will grind their teeth over the success or failure of ESPN for a long time, and the stock will be range-bound with a bias downward for a while.

The stock trades at $100 today. So you buy a September $110 call for a dollar, and you sell a September $105 put for $12. The money you make from this trade is driven by the embedded fear, loathing, and beta underlying the way in which the securities themselves are priced. Basically, when you sell a put, Beta is your friend. High Beta means the VIX on which the calls are priced is probably high, and when you write that put, you take in a nice chunk of premium for selling that short term stock 'life insurance' to a nervous nelly on the other side of the trade.

That said, you're the life insurance writer now, and if that stock flies northward while you're liable for the calls you just sold, you could lose all your premium and then everything up to the strike price of the call you bought. In this trade, you're writing a put for $12 and buying a call, basically betting that the stock during this period will trade in range, ending in your having taken in $1.50 in premium and having paid $1.00 for a call, to generate a low beta return of 30ish percent in a few months.

Yeah, good work if you can get it.

Why is this a bear call spread? Because you're the bear...and you want the stock to not take off, go up, soar, bust through the call prices in which you were long, and then have to execute and buy back that stock at, in this case, the $110 strike price.

The big idea here (and this notion is versus a Bear Put Spread) is that in a Bear Call Spread you get a premium (load of cash) up front, and you have a liability at the expiration that you may or may not need to shell out dough to buy the longer-dated call and settle the contract.

In a Bear Put Spread, you have to spend capital dough up front with an unknown, later-dated pay out. In a Bear Call Spread, the most you can make is that initial premium you've taken in by selling that higher priced call.

If the stock does nothing, then the other, longer-dated call expires, leaving you the holder with no liabiilty to deliver the shares, and you have collected all your initial-sale premium, with your expense having been the life insurance call you bought.

High strike. Low strike. Net premium received.

The maximum loss is limited. The worst that can happen at expiration is for the stock price to be above the higher strike. In that case, the investor will be assigned on the short call, now deep-in-the-money, and will exercise the long call. The simultaneous exercise and assignment will mean selling the stock at the lower strike and buying the stock at the higher strike. The maximum loss is the difference between the two strikes, but it's reduced by the net credit received at the outset.