Bear Call Spread: Strategy Risks

Posted on March 10th, 2010 admin
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It is important to always be aware of the strategy risks. The primary risk when placing a bear call spread is when the share price increases past the sold call option and an ever greater concern is if the share price increases above the bought call option (protection). Since you receive a premium to enter this trade there is a required margin. This margin can increase to as much as 1.2 times your maximum loss. For example if you were risk $5,000 the cash margin required in the account can increase to $6,000 (5000 *1.2) which includes the premium received. So it is important to know your maximum risk and make sure there are enough funds to cover the worst case scenario.

Another risk inherent with selling options is volatility. When you open the bear call spread you want the volatility to be high so you can sell the call options for as much value as possible. Once the trade is placed you want the volatility to drop off and time decay to kick in. So even if the share price stays still but volatility increases the position may not profit in the short-term. Increased levels in volatility mean to close out it will cost more to buy back the sold call option. If the share price increase above the sold put option prior to expiry there is potentially a risk of exercise.

Exercise

The main risk of credit spreads is the risk of being exercised. If the sold call option is exercised it means that you are obligated to sell shares at the exercise price of the sold call option. This can have a negative impact in terms of you have sold shares you do not own which means you need to buy them back at the higher level and therefore locking in a loss on that position. If the share price is above the bought call option (protection) when exercised then you can sell the call option which will reduce the loss from being exercised. It is still not possible to lose more than the maximum risk before entering the trade. Another disadvantage of being exercised is the brokerage on the share sale and purchase so it is a good idea to try an avoid exercise. To avoid being exercised you need to monitor your position and more importantly the delta of the sold call option. If the share price is above the sold call option an indication of the likelihood of being exercised can be identified by the delta. If the delta on the sold call option is above 0.95 there is a chance being exercised. If the delta is above 0.98 then it is necessary to implement one of your exit strategies.

To avoid exercise there are two options. If you think the share price will keep increasing you can close the trade for a loss. If you think you view is correct and the share price will fall from this level and want to keep the position you can roll out to the next month. What this means is you can close the positions you have an open the same position for the next month and do this for no cost or a small credit. Therefore if the share price then decreases below the sold call by the next month you can still make maximum profit. This options is normally recommended unless your analysis, technical or fundamentals, indicate a change is trend or market conditions.


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