8.1 – Choosing Calls over Puts

Similar to the Bear Put Spread, the Bear Call Spread is a two leg option strategy invoked when the view on the market is ‘moderately bearish’. The Bear Call Spread is similar to the Bear Put Spread in terms of the payoff structure; however there are a few differences in terms of strategy execution and strike selection. The Bear Call spread involves creating a spread by employing ‘Call options’ rather than ‘Put options’ (as is the case in bear put spread).

You may have a fundamental question at this stage – when the payoffs from both Bear Put spread and Bear Call spread are similar, why should one choose a Bear Call spread over a Bear Put spread?

Well, this really depends on how attractive the premiums are. While the Bear Put spread is executed for a debit, the Bear Call spread is executed for a credit. So if you are at a point in the market where –

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

And you have a moderately bearish outlook going forward, then it makes sense to invoke a Bear Call Spread for a net credit as opposed to invoking a Bear Put Spread for a net debit. Personally I do prefer strategies which offer net credit rather than strategies which offer net debit.

8.2 – Strategy Notes

The Bear Call Spread is a two leg spread strategy traditionally involving ITM and OTM Call options. However you can create the spread using other strikes as well. Do remember, the higher the difference between the two selected strikes (spread), larger is the profit potential.

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 there is always a ‘net credit’, hence the bear call spread is also called referred to as a ‘credit spread’. After we initiate the trade, the market can move in any direction and expiry at any level. Therefore let us take up a few scenarios to get a sense of what would happen to the bear put spread for different levels of expiry.

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 profitability of the strategy when the market falls further. At 7000, both the call options would expire worthless. While we treat the premium paid for 7400 CE i.e Rs.38 as a loss , we will retain the entire premium received for 7100 CE i.e Rs.136 as a profit. Hence the net profit from the strategy would be 136-38 = 98. Clearly, as and when the market falls, the strategy tends to make money, but it is capped to Rs.98.

Here is the payoff for the strategy at different expiries –

These payoffs can be plotted to get the graph of the strategy payoff –

As you can observe, the payoff is similar to a bear put spread where both the profits under best case scenario and losses under worst case scenario is pre defined.

8.3 – Strategy Generalization

Going by the above payoff we can generalize the key trigger points for the 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.

8.4 – Strike Selection and impact of Volatility

The following images help us identify the best call option strikes to choose, given the time to expiry. We have discussed the split up of time frame (1^st and 2^nd half of the series) several times before, hence for this reason I will just post the graphs and the summary table.

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

Expect 4% move to happen within	Higher strike	Lower strike	Refer graph on
5 days	Far OTM	ATM+2 strikes	Top left
15 days	Far OTM	ATM + 2 strikes	Top right
25 days	OTM	ATM + 1 strike	Bottom left
At expiry	OTM	ATM	Bottom right

Strikes to select when we are in the 2^nd half of the series –

Expect 4% move to happen within	Higher strike	Lower strike	Refer graph on
5 days	Far OTM	Far OTM	Top left
15 days	Far OTM	Slightly OTM	Top right
25 days	Slightly OTM	ATM	Bottom left
At expiry	OTM	ATM/ITM	Bottom right

The following graph talks about the variation in strategy cost with respect to changes in the volatility –

The graph above explains how the premium varies with respect to variation in volatility and time.

• The blue line suggests that the cost of the strategy does not vary much with the increase in volatility when there is ample time to expiry (30 days)
• The green line suggests that the cost of the strategy varies moderately with the increase in volatility when there is about 15 days to expiry
• The red line suggests that the cost of the strategy varies significantly with the increase in volatility when there is about 5 days to expiry

From these graphs it is clear that one should not really be worried about the changes in the volatility when there is ample time to expiry. However one should have a view on volatility between midway and expiry of the series. It is advisable to take the bear call spread only when the volatility is expected to increase, alternatively if you expect the volatility to decrease, its best to avoid the strategy.

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Key takeaways from this chapter

1. Bear call spread is best invoked when you are moderately bearish on the markets
2. You choose a bear call spread over a bear put spread when the call option premiums are more attractive than put options.
3. Both the profits and losses are capped
4. Classic bear call spread involves simultaneously purchasing OTM call options and selling ITM call options
5. Bear call spread usually results in a net credit, in fact this is another key reason to invoke a bear call spread versus a bear put spread
6. Net Credit = Premium Received – Premium Paid
7. Breakeven = Lower strike + Net Credit
8. Max profit = Net Credit
9. Max Loss = Spread – Net Credit
10. Select strikes based on the time to expiry
11. Implement the strategy only when you expect the volatility to increase (especially in the 2^nd half of the series)

Download Bear Call Spread Excel Sheet