BHP Bear Call Spread Example

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BHP Bear Call Spread

Trade

Sell 5 BHP Feb 09 3200 Calls @ 96

Buy 5 BHP Feb 09 3300 Calls @ 68

Net Credit = 28 cents

This trade requires margin requirements.

Maximum Profit

The ideal result is for the share price to stay below the lower strike price of $32.00.

Max Profit = Net premium received

= 96 -68

= 0.28 x 5 contracts

= $1400

Maximum Loss

This will occur if the share price is above the bought call option at expiry

Max Loss = Total spread less Net Premium Paid

= 0.72 * 5 contracts

= $3,600

Breakeven

Lower strike plus net premium received

Breakeven = 32.00 + 0.28

= $32.28

Risk vs. Reward

Risk 28 cents to make 72 cents profit.

Risk vs. Reward = 1: 0.3889

Main Benefits of Strategy

  1. Provides leveraged exposure to a fall in the share price
  2. Takes advantage of time decay
  3. The ideal result is for the options to expire worthless, which means the client will save on brokerage not having to close the position to take a profit.

Technical Analysis

  • Downtrend
  • Trade is above resistance
  • Share Price is below short-term moving averages


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Bear Call Spread vs. Sold Call

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A number of advantages are evident when trading bear call spreads compared to selling calls (naked calls). A bear call spread has considerable lower risk than just selling a call which technically has unlimited risk. The bear call spread has a much better risk vs. reward ration then a sold call option. Selling calls have a number of benefits when combined with shares or portfolios that can help produce income. This strategy is called covered calls and will be in another e-book.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Strategy Risks

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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.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Trade Analysis – Risk vs. Reward

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Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bear call spread.

2. Determine premium received when entering trade, most important as it is also your maximum profit.

3. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.

4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk vs. reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). Bear call spreads can be positioned to risk $0.50 to make a $0.50 this is when the bear call spread is traded at the money (Risk vs. reward 1:1). The trade can be more cautious by selling out-of-the-money options where you risk $0.80 to make $0.20 (Risk vs. reward 4:1). Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Technical and Fundamental Analysis

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Technical Analysis

Identifying bear call spreads can be assisted through technical analysis. Technical analysis allows identification of expected price movement through indentifying trends through momentum indicators and trend lines. The types of chart patterns you are looking to identify a bear call trade are:

  • Strong resistance levels
  • Down trends
  • Trading ranges

Fundamental Analysis

Fundamental analysis can determine if a trade is viable or not. There are a number of fundamental factors that influence the option prices of a stock. When identifying a bear call spread you have a bearish outlook on the share. Therefore you are looking for negative news in the company or sector. As this trade also makes money if the share price does not move it if there is no news coming out of the company for the next month this can also be a positive for this particular strategy.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Identifying Trades – The Greeks

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Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bear call spread. The net delta is calculated by the delta of the bought call option minus the delta of the sold call option. The net delta will always be positive. The net delta indicates if the share price decreases quickly what the value of the bear call spread will be worth. For example, if a bear call spread had a net delta of 0.20, and the share price decreased by $1.00, the bear call spread would have decreased by 20 cents.

Vega

The volatility affect on a bear call spread is varied. When looking to enter a bear call spread you look to sell an out-of-the-money call option. The idea is to sell a call which has a relatively high volatility and therefore trading above its theoretical value. The bear call spread can be traded when volatility is high on the call option which allows the spread to be higher above the current share price so the stock would have to increase further before affecting the trade.

Theta

Credit spreads are trades that take advantage of the time decay nature of options. The effect or time decay is a positive for this trade. When the share price is below the sold call if the share price and volatility remain constant this value of the position will reduce and therefore increase your profit. If the stock price is closer to the lower strike price of the sold call, profits generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the bought call, profits generally decrease at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Option Pay-Off Diagram

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It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and breakeven level at expiry. The bear call spread is made up of a sold call option and a bought call option at a higher strike. When combined it creates a bear call spread. See below for how the bear call option pay-off diagram is constructed. The dotted green line is the sold call and the dashed green line represents the bought call.

Sold Call


Bought Call


Bear Call Spread


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: The Psychology

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The reasoning behind placing a credit spread is different to placing a debit spread. Bear Call Spreads and Bull Put Spreads are credit spreads. They are not as aggressive cause you do not need the share price to move to far in a certain direction for instance a bear call spread profits if the share price goes sideways or fall whereas the bear put spread requires the share price to fall to a certain level for maximum profit. This strategy profits from time decay.

The expected share price movement is neutral to slightly bearish. Selling a call option out-of-the-money you receive premium if the share price is below the sold call option strike price at expiry the premium received is the profit. The bear call spread just means you buy a call at a higher level then you sold the call to cap your risk and indentify you maximum risk rather than having no protection and potentially unlimited risk for a small percentage credit. The reasons for trading bear call spreads are;

  • Alternative to naked calls (selling calls with no protection) as you have a predefined profit and loss and a better risk vs. reward ratio.
  • Share price outlook may be neutral to slight bearish on the share price due to a resistance level.
  • Consider the bear call spread when you are expecting a small fall in the price of the stock.
  • The trade of with placing a bear call far out of the money is that the stock price can increase in share price slightly, stay flat or fall to make a profit. So even if you are wrong you can still profit from the trade.
  • This strategy can be used to produce income.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Advantages and Disadvantages

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Advantages of Bear Call Spread

  • Loss is limited if the underlying financial instrument rises instead of falls.
  • If the underlying instrument fails to drop below the strike price of the out-of-the -money sold call option, the profit yield will be greater than just buying put options.
  • Able to profit even when the underlying asset remains completely still.
  • Lower risk than simply writing naked call options as maximum downside is limited by the bought call option.

Disadvantages of Bear Call Spread

  • There will be no more profits possible if the share price drops beyond the strike price of the sold call option.
  • Because it is a credit spread, there is a margin requirement in order to put on the position.
  • As long as the short call options remain in-the-money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the sold call obligation.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au