- Bear call spread is an option strategy used by traders to cap their maximum loss.
- At first, a trader is bearish with the downside capped, so he initiates a sell call option, i.e., the spot price is higher than the strike price.
- In a sell call option, maximum profit is fixed, which is equal to the premium received and the maximum loss is unlimited.
- If the price falls as he expects, the maximum profit will be the premium received.
- However, the trader later observes a support level at the bottom and expects the trend to be bullish.
- Suppose the trader’s worry became true and the price started to revert back from the support. The trader will fall into huge loss.
- To reduce his loss, he initiated a buy call option, such that the strike price of the buy call option is more than the strike price of the sell call option.
- In this case, the trader receives a higher premium for the sell call option than he pays to the buy call option.
- If the price falls, the trader would incur a profit in the sell call option but at the same time incur a loss in the buy call option.
- Since the gain is higher than the loss, the profit is now limited and it is equal to the difference between the premium received and the premium paid.
- If the price rises, the trader would incur a loss in the sell call option but at the same time incur a profit in the buy call option. Since the loss is higher than the gain, the loss is now limited.
- This way, the trader reduced his maximum loss, from unlimited to limited.
Consider an example: a trader initiated a bear call spread option strategy
Short Call: Strike Price = 1000 & Premium Received = 40
Long Call: Strike Price = 1050 & Premium Paid = 30
P/L = Profit/Loss
The graph clearly depicts the difference between a sell call option and a bear call spread option.
In the second strategy, the maximum loss is limited.