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With a bear call spread, investors can profit from premium income by simultaneously selling a call at a lower exercise price and buying a call at a higher exercise price. This option strategy has a significant advantage over selling a simple call. The risk of loss from the call short is reduced to the spread between the different strike prices by simultaneously buying a call. Here you can find out how this can be used.
Formation of the Bear Call Spread and effects in different market situations
The call short is hedged by a call long out of the money at a slightly higher strike than for the call short. The premium to be paid for the call long is also much lower than the premium received for the call short with the lower strike price.
Although the effective premium income is reduced, it is still positive. This means that if the share price stagnates or falls, a profit is made. A profit is still possible even if the share price rises only slightly.
The advantage of the “insurance” over the purchase of the call option is that the risk of loss is limited to the difference between the two exercise prices for the call long and the call short in the event of a sharp rise in the share price.
The investor profits with the Bear Call Spread in the event of a falling or stagnating price, because the sold Call Option is not exercised. If the price rises only moderately, the investor can also profit from the bear call spread.
The buyer of the call will only exercise the option if a profit is made, taking into account the premium paid.
Advantages of the Bear Call Spread Strategy
- Profit through premium income from the sale of a call
- strongly limited risk of loss due to the purchase of the call at a higher exercise price
Disadvantage of the Bear Call Spread Strategy
- Premium income is reduced by the option price to be paid for the call long
Example of a Bear Call Spread
It is assumed that a share has a current price of €110. For example, an investor can sell a call at an exercise price of €113. He believes that the price will not rise any further, but will fall or move at most. In return he receives an option premium of €1.60 per share from the buyer of the call. Related to 100 shares, he can therefore earn 160 €.
For hedging purposes, he simultaneously buys a call at an exercise price of €118. The exercise price for the call long must be one unit higher than for the call short. For the call long, an option price of €0.95 per share must be paid. For 100 shares, the amount to be paid is € 95. This leaves a difference of €65 or €0.65 per share for the investor.
If the share price falls within the option term or moves on the spot, the buyer will not exercise his call option because he would otherwise make a loss. In these cases the investor does not need to deliver the shares at a price of 113 € per share. He keeps the 65 € from the collected option premium for the call short, considering the paid premium for the call long.
The risk from the bear call spread will only become effective if the share price actually rises sharply, contrary to the assumptions. The risk limit, however, runs at a price of €118 because at this price the call hedge is long.
The loss then corresponds to the difference between the two exercise prices, less the still positive balance from the premium received for the call short. In relation to 100 shares, this is 500 €, minus the 65 € remaining from the premium received for the call short. Compared to a simple call without hedging, this is a great advantage because the risk of loss in the event of an increase in the share price is theoretically not limited.
Read my other articles about options:
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