Construction

It is the writing of ITM calls and the simultaneous purchase of the same number of OTM calls, with the same expiration, on the same underline security.

 

 

 

It is a credit spread because the money we earn from the short call is more than the money we have to pay for the long call.

When to use

When we believe that the price of the underline will fall, but not very much. In order to take advantage of the decline we write ITM calls with a certain premium and we expect to profit from expiring worthless or buy them back at a lower price. As we know the naked short call strategy is very risky and has unlimited potential losses, so simultaneously we are buying the same number of OTM calls in order to protect ourselves from an upward movement. We accomplish maximum profit when the stock price at expiration is at or below the strike price of the ITM call and maximum loss when it is at or above the strike of the OTM call.

Loss/Profit at expiration

Maximum loss: (Long call strike – short call strike) – net premium earned + commissions.

Maximum profit: Net premium earned – commissions.

Profit/Loss diagram

Below we can see the profit/los diagram for the call bear spread. We assume that we have written 1 ITM call with strike $25 and premium $3 and we have bought 1 OTM call with strike $30 and premium $1. The stock price when we opened the position was at $27.50. Notice the similarity to the put bear spread profit/loss diagram.

Call bear spread strategy example

In the daily chart of stock C (below) price has visited for the first time at point A a strong resistance zone (not shown for space reasons). The possibility of a reversal is very high, but due to the fact that the market is in midterm uptrend we don’t expect a very big drop in the stock price during the next month. Our expectation of a modest decline is fortified because of the support near $31 (line 2).

In this case we can write an ITM call with strike $32 and expiration after 1 month and buy an OTM call with strike $38 in case the stock keeps on advancing above the resistance. We want the price of the underline to be bellow or as much as close to $32 until expiration. We can also close the position at anytime.

If we were expecting a big decline then it would be better to employ a different strategy because the call bear spread imposes a limit on maximum profits even if the stock price is plummeting.