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The Bear Call Spread should be used when you feel negative about a stock/index that it will go down in price.
Simultaneously,
- Sell Lower Strike Call Option
- Buy Higher Strike Call Option with the same expiry month
Example – Bear Call Spread with 10 Contracts
Using the same index as we have used earlier for our Bull Put example, let us continue using OEX to explain the bear call spread. OEX at 570 – you feel bearish about this index. You can now enter into bear call spread by selling the 575 call @2.50 and buying the 580 call for $1.80. Again, you collect an upfront premium or credit which will be your maximum profit. For this position, you will collect $0.70 ($2.50 – $1.80). For 10 contracts, your maximum profit would be $700 ($0.70 x 10 contracts x 100 units per contract).
Your maximum loss can be calculated by subtracting the difference between the strike prices less the $700 that you received upfront. Your maximum loss would be $4300 ($5000 - $700). Your return on investment for this spread is 16.28% ($700/$4300).
What is the best time to enter a Bear Call Spread?
Market Downtrends
Generally speaking, if the major indices are on strong downtrends, then you would want to focus more on bear call spreads. However, if the market is oversold, you have to be cautious with your entry. Markets rarely move in a straight line. A market that is oversold will come with corrections. Watch out for reversal signs.
Sideways Markets
When the major indexes have been trending sideways and are showing no strong trend in either direction, then the credit spread investor might want to have a mix of bull put spreads and bear call spreads. Again, as history would show, the indices have a tendency to move higher over time, the mix of trades should usually be biased towards the bullish side.
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