Bear Call Spreads... Protect Yourself And Profit In Bearish Markets

Some traders create a steady stream of income by selling naked options. This means selling options, generally far out of the money, collecting the premium and letting time decay work in your favor until the option is worthless and you keep the premium. Sounds smart, right?

Well, this strategy is wrought with danger and risk. It can and does work, however any type of severe move in the underlying can put your account in danger. Your profits are limited to the option price, but your losses are theoretically unlimited.

Unexpected company announcements, surprise Fed moves, geo-political events, or any number of occurrences have become the financial death of many option sellers. Entire hedge funds have been built on the back of this option selling strategy, however many blow up spectacularly, leaving the investors holding the bag. Is there a way to maintain the benefits of selling options, yet eliminate most of the extreme risk?

Yes, a strategy called "option spreads" fits this criterion fairly well. Spreads profit from selling options, yet your risk is limited and pre-defined. Unfortunately, your profit is limited also.

This article will focus on a spread strategy known as Bear Call Spreads. They are used when one expects the underlying stock or index to decline in value. The basic gist of the strategy is selling calls at a specific strike price then buying the exact number of calls at a higher strike price.

Normally, the Bear Call Spread is created by selling at the money calls and buying out of the money calls. The maximum profit is the credit received from the trade and is earned when the closing price is below the lower priced call. The maximum downside is the difference between the strike prices minus the credit. The maximum loss occurs when the underlying closes at or above the strike price of the long option.

Bear call spreads seem to be the choice of many traders in this current market environment. Let's take a look at a current example with the Dow Jones Industrial Average using the ETF DJIA as the underlying instrument:

We will use the June 120 and June 123 calls. The June 120's code is DAWFP, and the June 123 is DAWSF - DAWFP is trading at $3.35 by $3.50 and DAWSF is currently trading at $1.55 by $1.57.

There is nice open interest on both sides of this spread, and the deltas are 120-0.67, 123-0.44. The break even point on this trade is $121.95, the maximum profit would be $105.00 and the maximum loss would be $195.00.

Most option brokers, like ThinkorSwim or OptionsXpress provide chains of spreads, with analytics on each one, making it easier for you to choose the correct Bear Call Spread for the situation. Remember, Bear Call Spreads are used when you have a bearish bias on the market and they are relatively safe compared to simply selling calls. However, the downside is that your profits are also capped.

Good Luck!

Dave Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.