Bear call spread option strategy
A short call spread obligates you to sell the stock at strike price A if the option is assigned but gives you the right to buy stock at strike price B. A short call spread is an alternative to the short call.
One advantage of this strategy is that you want both options to expire worthless. You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the further out-of-the-money the strike price is, the lower the net credit received will be from this strategy. As a general rule of thumb, you may wish to consider running this strategy approximately days from expiration to take advantage of accelerating time decay as expiration approaches.
Of course, this depends on the underlying stock and market conditions such as implied volatility. You may also be expecting neutral activity if strike A is out-of-the-money. You want the stock price to be at or below strike A at expiration, so both options expire worthless.
The net credit received when establishing the short call spread may be applied to the initial margin requirement. Keep in mind this requirement is on a per-unit basis. For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold good but it will also erode the value of the option you bought bad. After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons.
First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing which will hopefully be to the downside. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
This maximum risk is realized if the stock price is at or above the strike price of the long call at expiration. Short calls are generally assigned at expiration when the stock price is above the strike price.
However, there is a possibility of early assignment. A bear call spread earns the maximum profit when the price of the underlying stock is below the strike price of the short call lower strike price at expiration. A bear call spread is the strategy of choice when the forecast is for neutral to falling prices and there is a desire to limit risk.
A bear call spread benefits when the underlying price falls and is hurt when it rises. Also, because a bear call spread consists of one short call and one long call, the net delta changes very little as the stock price changes and time to expiration is unchanged. Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices.
As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bear call spread consists of one short call and one long call, the price of a bear call spread changes very little when volatility changes and other factors remain constant.
This is known as time erosion. Since a bear call spread consists of one short call and one long call, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread.
This happens because the short call is closest to the money and erodes faster than the long call. This happens because the long call is now closer to the money and erodes faster than the short call. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bear call spread, because both the short call and the long call erode at approximately the same rate.
Stock options in the United States can be exercised on any business day, and holders of a short stock option position have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options. While the long call higher strike in a bear call spread has no risk of early assignment, the short call lower strike does have such risk.
Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
Therefore, if the stock price is above the strike price of the short call in a bear call spread the lower strike price , an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. The entire spread can be closed, which involves buying the short call to close and selling the long call to close.
Alternatively, the short call can be purchased to close and the long call open can be kept open. If early assignment of a short call does occur, the obligation to deliver stock can be met either by buying stock in the marketplace or by exercising the long call.
Note, however, that whichever method is chosen, the date of stock acquisition will be one day later than the date of the stock sale.
This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the stock position created by the option assignment.
There are three possible outcomes at expiration. The stock price can be at or below the lower strike price, above the lower strike price but not above the higher strike price or above the higher strike price. If the stock price is at or below the lower strike price, then both calls in a bear call spread expire worthless and no stock position is created.