With This Options Strategy, You Can Play It Safe (And Still Earn Income)

Options contracts can be versatile tools. Traders can use them to hedge a portfolio, generate income, make speculative bets with minimal capital risk, and more.

Today, let’s discuss an income strategy that works well for traders who want to go a level beyond simply selling puts or selling covered calls.

We’re talking about a bear call spread.

This strategy can serve to help traders generate income while limiting risk. It works well for stocks you expect to remain stable or decline soon. And if you can learn to master this technique, you’ll see how it can pay off significantly.

Setting Up a Bear Call Spread

As we discussed recently, spread trades typically involve two or more options contracts. The goal is to use two contracts that work together to create a particular potential return profile, along with specific risk qualities. Option spreads can be used to benefit from multiple scenarios, including bearish, bullish, and flat price action.

Let’s say you have a stock you think will drift lower or, at minimum, remain stable. This is where a bear call spread comes into play. This is set up by purchasing a call option and then selling the same number of call options. Both positions are on the same underlying security with the same expiration date. The only difference is the strike price.

Let’s use an example of a stock currently trading near $63. We can sell the three-month $60 calls and purchase the three-month $65 calls.

The $60 calls are considered in the money, meaning they already have intrinsic value. This is because the owner could exercise his right to purchase the stock at $60, which would be below the current market price.

On the other hand, the $65 calls are out-of-the-money, meaning the stock has not yet crossed above the strike price. While an investor may pay a particular price for these options based on the expectation that the stock may trade above the strike price, there is no benefit in exercising the call option. This is because you could purchase stock cheaper in the open market.

The $60 calls will therefore be worth more than the $65 calls. So when we sell the $60 calls and buy the $65 calls, we receive a credit for putting on the trade. Depending on the volatility of the stock, we could expect to receive, say, $4.50 for selling the calls. And we may pay $1 to buy the calls, for example. This would result in a net credit of $3.50 for the trade.

Source: Options Industry Council

Three Possible Outcomes

There are three possible scenarios for how a bear call spread can work out.

  • First, the stock could fall below the lower strike price. This represents our maximum profit opportunity.
  • Second, the stock could close between the two strike prices. This would leave us with a short position in the stock, which may or may not be profitable, depending on the price.
  • Third, the stock may exceed our highest strike price, resulting in our maximum (capped) possible loss.

In the first scenario, we gain our maximum profit because neither call option will be exercised. This means we get to keep the $3.50 that we received when entering the trade.

In the second scenario, we will be obligated to short shares of the stock at the lower strike price. This is because the owner of the $60 call option has an incentive to buy shares from us at $60 rather than paying a higher market price for the stock. So we will essentially take on a short position with a cost basis of $60, but we still get to keep the $3.50 we received from setting up the trade. So our breakeven point is $63.50.

In the final scenario, if the stock trades above $65, we will still be required to short the stock at $60, but we will also have the right to buy shares at $65. This means we will take a $5 loss as we are purchasing the stock $5 higher than we are selling it. However, since we received $3.50 per share when setting up the trade, our net loss will only be $1.50.

Closing Thoughts

Still with us? Hopefully, you’ll understand after reading this that a bear call spread is a great way to benefit from a stable or falling stock price while limiting risk. Profits are typically accumulated when the stock is stable. They are highest when the stock trades below the lower strike price. At the same time, our risk is capped to the maximum loss if the stock trades higher.

Again, we’ll reiterate that it’s important for traders to at least become familiar with these types of strategies. You may decide in the end that they aren’t right for you at this time. But the day may come, particularly as you gain confidence with your trading, that you may decide a strategy like this can greatly benefit you.

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