A bear call spread is a credit spread created by purchasing a higher strike call and selling a lower strike call with the same expiration dates. This strategy is best implemented in a moderately bearish or stable market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required to buy the stock or futures contract. The strategy has both limited profit potential and limited downside risk.
Steps to Using a Bear Call Spread
1. Look for a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock-not a large move.
2. Check to see if this stock has options.
3. Review call options premiums per expiration dates and strike prices.
4. Investigate implied volatility values to see if the options are overpriced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume charts over the last year.
6. Choose a higher strike call to buy and a lower strike call to sell with the same expiration date.
7. Calculate the maximum potential profit by computing the net credit of the two option premiums.
8. Calculate the maximum potential risk by multiplying the value per point by the difference in strike prices and subtracting the net credit received.
9. Calculate the breakeven by adding the net credit to the lower strike price.
10. Create a risk profile for the trade to graphically determine the trade’s feasibility.
11. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
12. Contact your broker to buy and sell the chosen call options.
13. Watch the market closely as it fluctuates. The profit on this strategy is limited – a loss occurs if the underlying stock rises to or above the breakeven point.
14. To exit the trade, you need to sell the higher strike put and buy the lower strike put or simply let the options expire.
Todd Mitchell is the CEO & Founder of Trading Concepts, Inc. He's been trading since 1994 and has mentored over 12,000 traders from Wall Street to Main Street. He's an expert at developing strategies for creating more consistent daily, weekly and monthly income.
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