Bear Call Spread: Meaning, Strategy & Example for Options Trading
Derivative instruments like futures and options help manage portfolio risks. Many people also use them purely for speculative trading. However, the price behaviour of futures and options can be more complex compared to their underlying equity shares. Therefore, it’s crucial to thoroughly understand derivative strategies before taking any position. This article discusses the bear call spread strategy, a popular options trading technique that investors and traders use in a weak or bearish market.
What is a bear call spread?
A bear call spread is an options-based trading strategy that investors and traders adopt when they expect a bearish trend in the market. Stock market professionals also refer to this as bear spread option strategy. It usually involves selling an in-the-money (ITM) call option with a lower strike price and buying a call option with a higher strike price simultaneously. However, executing this strategy successfully requires a proper understanding of options and market conditions.
Key terms to understand
For those without a background in options trading, here are a few essential terms:
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Strike price: It is the pre-specified price of the underlying asset at which option buyers can exercise their options. For Call option buyers, it is the right to buy the underlying assets at the strike price. For Put option buyers, it is the right to sell the underlying asset at the strike price. Example: If the Nifty 50 has Call and Put options at 25,000, Call buyers have the right to buy Nifty 50 at 25,000 on the option’s expiry date, while Put buyers have the right to sell it at 25,000.
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In-the-money (ITM): An option is considered in-the-money when exercising the right is profitable for the option buyer. Example: A Nifty 50 Call option with a strike price of 25,000 is ITM when the Nifty 50 is above 25,000. Call buyers can buy Nifty 50 at 25,000 and sell it at the higher market rate, making a profit from the price difference.
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At-the-money (ATM): An option is at-the-money when the underlying asset is trading at or very close to the strike price. Example: A Nifty 50 Call option with a strike price of 25,000 is an ATM when the Nifty 50 or its futures are trading around 25,000.
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Out-of-the-money (OTM): An option becomes out-of-the-money when exercising it is no longer profitable for the buyer. Example: A Nifty 50 Call option with a strike price of 25,000 is OTM when the Nifty 50 futures are trading significantly below 25,000.
Condition required for a bear call spread
A bear call spread works best when the market is trading flat or slightly bearish with an expected downward trend. However, this strategy is not ideal during sudden, sharp price movements, either a steep market crash or a strong upward rally, as these situations can significantly affect profitability.
How does the bear call spread strategy work?
The bear call spread involves two simultaneous transactions:
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Transaction 1 (selling): Depending on prevailing market prices, sell an ITM call option. It can also be an ATM Call. The seller receives the Call’s premium. But investors should avoid selling deep OTM Calls as they carry negligible premiums.
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Transaction 2 (buying): The second leg of the bear Call spread strategy is buying OTM Calls with higher strike price.
Key points to remember when executing a bear call spread:
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Both short and long Calls must have the same expiry date and the same underlying asset (e.g., Nifty 50).
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It is crucial to perform Transaction 1 and Transaction 2 simultaneously, with the least delay in between.
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The option premium received from Transaction 1 (selling ITM or ATM Calls) must be higher than the premium paid in Transaction 2 (buying OTM Calls).
Key concepts behind bear call spread strategy
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Maximum profit (fixed): The maximum profit from this strategy is limited and predetermined. It equals the difference between the Call premium received from selling and the premium paid for buying Calls.
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Maximum loss (limited): Loss happens when the underlying asset price goes above the strike price of the Calls the investor sold. However, purchased Calls start giving profit, offsetting the loss.
Maximum loss = (Market price - Short Call strike price) - net premium received
- Break-even point (BEP): It is the market price of the underlying asset at which the bear spread strategy offers neither profit nor loss.
Break-even point of the trade = Lower strike price + net premium received from the trade
Example: Bear call spread on Nifty 50 futures
Let’s understand the bear call spread strategy with an example.
Underlying asset: Nifty 50 futures
Expiry date: September 2025
Current Nifty 50 level: 24,836.00
Positions taken:
- Sold Calls of strike price 25,100 @ ₹51/-
- Bought Calls of strike price 25,300 @ ₹8.5/-
Scenarios (different market situations at options expiry)
Nifty 50 closes at 24,000
Profit = Net premium received = (51 - 8.5) = ₹42.5/-
Nifty 50 closes at 25,300
Loss = (Market price - strike Calls strike price) - net premium received = (25,300 – 25,100) - 42.5 = 200 - 42.5 = ₹157.5/-
Nifty 50 closes at 25,600
Loss from sold Calls = (market price - strike price of the sold Calls) - net premium received = (25,600 – 25,100) = ₹500/- Profit from purchased Calls = (Market price - Strike price of purchased call) - Call premium paid = (25,600 – 25,300) = ₹300/- Net loss from the bear spread = (500 - 300) - 42.5 = ₹157.5/-
| Nifty 50 closes at 24,000 | Nifty 50 closes at 25,300 | Nifty 50 closes at 25,600 |
|---|---|---|
Both Calls expire at OTM | Sold Calls of 25,100 are ITM. Bought Calls of 25,300 are ATM | Sold Calls of 25,100 are ITM Bought Calls of 25,300 are ITM |
Profit = Net premium received = (51 - 8.5) = ₹42.5/- | Loss = (Market price - strike Calls strike price) - net premium received = (25,300 – 25,100) - 42.5 = 200 - 42.5 = ₹157.5/- | Loss from sold Calls = (market price - strike price of the sold Calls) - net premium received = (25,600 – 25,100) = ₹500/- Profit from purchased Calls = (Market price - Strike price of purchased call) - Call premium paid = (25,600 – 25,300) = ₹300/- Net loss from the bear spread = (500 - 300) - 42.5 = ₹157.5/- |
So, the maximum loss is ₹157.5 The breakeven point for the trade will be (Lower strike price + net premium received) or (25,100 + 42.5) or 25,142.5. So, if Nifty 50 closes at 25,142.5 at the expiry, then there will be neither loss nor profit.
Conclusion
Time decay works in favour of investors using a bear spread strategy. As the expiry date nears, the intrinsic value of the option declines, reducing the overall risk of the trade. Besides, since the maximum loss is capped, this strategy allows traders to take a bearish position with controlled risk. If you are bearish on a particular stock or index, you can adopt this strategy with a limited risk.
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in securities market are subject to market risks, read all the related documents carefully before investing. Brokerage will not exceed SEBI prescribed limit. The securities are quoted as an example and not as a recommendation. SEBI Registration No-INZ000200137 Member Id NSE-08081; BSE-673; MSE-1024, MCX-56285, NCDEX-1262.
