A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.
To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.
To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.
An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.
The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price.
Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.
The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.
An example of a bearish call spread.
Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15.
In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Net premium received
= 15 - 5 = 10
Maximum loss = Higher strike price option - Lower strike price option - Net premium received
= 110 - 90 - 10 = 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100
To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.
To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.
An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.
Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.
The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.
An example of a bearish call spread.
Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15.
In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Net premium received
= 15 - 5 = 10
Maximum loss = Higher strike price option - Lower strike price option - Net premium received
= 110 - 90 - 10 = 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100
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