Bear Call Spreads: Profit From Stocks Trading Lower
Think you can only make money when stocks are trading higher? Think again! Bear call spreads are excellent for capturing income from stocks you expect to trade lower. And unlike shorting shares of stocks or buying put contracts, your risk of loss is limited and you’re not fighting a ticking clock.
Editor’s Note: This is part three of a multi-part series on credit option spreads. See also:
- Part I – Credit Option Spreads: Great Tools for Income Investors
- Part II – Bull Put Spreads: Income From Stocks Moving Higher
- Part IV – Spread Trade Permission: A Must for Income Investors
- Part V – When Should I Close Credit Spread Trades?
Stay tuned for more articles to come!
Just like our previous discussion, we’ll start with how bear call spreads are put together. Then we’ll cover what could happen with your trade. Finally, I’ll show you why this tool can make you a more versatile trader with more reliable profits.
The Two Parts Of Bear Call Spreads
Bear call spreads are created when you sell one call contract and buy another call contract. The combination of these two transactions gives you a chance to generate income on the spot, while strictly limiting your risk.
For our example today, let’s assume you’re bearish on Tesla Motor (TSLA) shares. You believe the stock will likely trade lower, but you don’t want to take too much risk. You know that Tesla enthusiasts have a tendency to buy shares whenever a surprise announcement is made.
Shares of TSLA closed at $230.61 on Thursday. You’re bearish on TSLA and believe that shares will be trading below $235 two months from now.
For our bear call spread, we’ll be using September put contracts. These contracts expire on the third Friday in September. That’s just a bit less than two months from now.
To enter the bear call spread, we will simultaneously:
- Sell the TSLA September $235 call contract, priced near $9.70
- Buy the TSLA September $245 call contract, priced near $6.70
Notice the strike price for the call we are selling is lower than the strike for the call we are buying. Also, we are receiving more cash for the call contract we sold, than we are paying for the call contract we purchased.
Between the $9.70 per share we receive and the $6.70 per share we pay, we’re clearing $3.00 per share in income. Since each contract represents 100 shares, that’s $300 deposited into our account for each unit we enter.
We call this type of trade a “credit” spread because we received a credit for the two parts of this trade.
Here’s What Can Happen…
Remember, selling a call contract is simply entering an agreement to sell shares of stock at a certain price. You don’t need to already own a call contract to sell (or to enter this agreement).
By selling the TSLA September $235 call contract, we’re agreeing to sell shares of TSLA at $235, but only if TSLA is trading above $235 when the call contracts expire. Also, by buying the TSLA September $245 call contract, we’ve got the right to buy shares of TSLA at $245. Even if shares are trading above this level in September.
That’s important because it strictly limits how much risk we have in this trade.
Once you enter bear call spreads, there are basically three potential outcomes…
Three Potential Scenarios
1) The stock could close below your bottom strike price. In our example, shares of TSLA could close below $235. This would be the best case scenario for us. If shares are below $235, both call contracts will expire worthless. That means we keep the $300 per contract and the trade is closed.
2) The stock could close above your top strike price. In our example, shares of TSLA could close above $245. This would be the worst case scenario for us.
If shares are trading above $245, we will be required to sell shares at $235. That’s because the call contract we sold obligates us to sell shares at $235. But we also have the right to buy shares at $245. That’s because we bought our $245 call contract. So no matter how high TSLA trades, our biggest risk is that we have to buy shares at $245 and sell them at $235.
You might think we’re stuck with a loss of $10 per share (or $1,000). But we’re actually in better shape than that. Since we already collected $300 per contract from entering the trade, our maximum possible loss is only $7.00 per share (or $700 per contract).
3) The stock could close between the two strike prices. In our example, TSLA could close between $235 and $245. Typically if I see that this is going to happen, I will close out one or both sides of this trade so I am not left with a position in TSLA after expiration.
Depending on where the stock closes — or what we pay to close out our call contracts — we may lose a bit less than our $7.00 maximum risk, or we may make a profit that is slightly less than our $3.00 per share maximum gain.
Lower Returns, But Lower Risk and Less Capital Required
Bear call spreads are a great way to generate reliable income payments — especially in bear market periods. But these trades won’t hand you a 100% profit in a few weeks time, or knock the ball out of the park.
I like to use bear call spreads because these trades allow me to know for certain how much is at risk with each trade. Better yet, my broker knows that my risk is capped too.
Brokers who allow spread trades like this have special rules that only require you to put up enough capital to cover your maximum loss. This way, I can make a bearish bet on a high-dollar stock like TSLA without tying up nearly $25,000 of my capital at one time.
To use this type of spread trade effectively, you’ll need to have a margin account and permission to enter spread trades in your account. We’ll talk about more of the details for how to get started over the next few days.
Oh, and please let me know what questions you have so far! Hopefully I can help you understand these specialized trades so you have another great income tool for your investment account. Feel free to comment on this article or email me any time (Zach@ZachScheidt.com).