Bear Call Spread Explained
Bear Call Spreads, or Credit Call Spreads, are a really great way to secure a weekly income. Your max profit isn’t much, but your max loss is anywhere from zero to not very much.
The confusing part is when you look up bear spreads, and get this picture…
THIS IS NOT HELPFUL
I didn’t Google “credit spreads explained” because I understood what the chart means. Let’s be real.
Btw, bear spread, call debit spread, call credit spread, bull spread….are all types of Vertical Spread. I have to doublecheck, but I’m fairly certain this is a “squares are rectangles, but rectangles aren’t squares” scenario. Or maybe it’s the opposite, but in reverse. Moving on…
Okay so ignore the chart for a second. Let’s jump right into an example using Nokia’s ADR, NOK. (I just wanted to sound smart, it doesn’t really matter that it’s an ADR. It’s still Nokia). An ADR is a way of investing in a foreign stock without investing directly into a foreign stock. I bought some shares in an Australian company recently, and that cost me $50 just for buying a foreign stock. With the ADR, you aren’t buying a foreign security, even though it essentially represents the foreign security and its price is pegged to it…..Whatever, doesn’t matter. Ticker symbol is NOK, that’s all we need to know.
So Nokia has been at $4-$4.50, more or less, for the last six months. So, we’ve been writing covered calls on Nokia at $4 and $4.50, sometimes $5. rockydennispresents.com/covered-call-tutorial
Let’s say we want to write a call, but we’re going further out on expiry, or maybe we just want to hedge against an uptick in price. So we write our $4 call, and buy a $4.50 call. Now if the price goes down, as it has this week ($3.78 at time of writing), then both options expire worthless. If the price moves to $4.25, we lose our shares and the buy option expires worthless. If the price moves to $4.75, we lose our shares but can exercise the $4.50 call and sell the shares for $4.75 for a $25 profit. If the price keeps going up, well, hey, $$$.
So now why is it so damn confusing when we do this on Robinhood? Well, why are you opening spread positions on Robinhood? Yeah, so, we’re both right.
What’s happening is that we aren’t differentiating between COVERED spreads and uncovered.
When we own the underlying stock already, we can set ourselves up into a guaranteed profit scenario, depending on what we paid for the underlying. Let’s say we buy NOK at $4. Sell Call $3.50, Buy Call $4.50. If the price drops, we keep our shares and our premium. If the price stays the same, lose our shares but probably break even if we add the premium and subtract the cost of the buy option. If the price goes up significantly, we lose our shares plus can take profit on the $4.50 call.
“But Rocky!”, you say, “I feel the synapses firings, but I still am missing something!”. Yeah, I feel ya. So when you look at the chart above, that is describing the profit/loss potential of an uncovered credit spread. See, Robinhood won’t let you write uncovered calls, but YOU can write multiple calls against the same underlying shares, thanks to spreads. (This can be abused for profit, but again, why use RH at that point?)
If you don’t own any underlying, you just have to put up the collateral to cover your potential loss if the price moves against you. However, if you DO own the underlying, Robinhood can get confused and end up causing you to execute one or more day-trades at expiration, or put you into debt (if you don’t have enough cash balance to cover any losses incurred due to writing uncovered calls).
So if all you have is cash, and no underlying, and NOK is $4, and you open a spread by Selling $4 Call and Buying $4.50 Call, and the price goes to $5, you buy the stock at $4.50 and sell it at $4. You lost $50, BUT you would have lost $100 if you had not purchased the $4.50 call. So your loss was $50+premium, which is less than $100. If the price goes down or stays the same, your max profit is the premium received from selling the $4 call.
TLDR
The Chart Shows Uncovered Bear Call Spread
Max Profit is premium received from the short call.
Max potential loss is the (long call strike - short call strike) + premium paid for long call.
When strike price of call option sold is lower than strike of call option bought, the spread is bear.
If the strike of the call option sold is HIGHER than the strike of the option you buy, the spread is bull.
It works the same with Puts, but it’s the opposite in reverse.