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Bear Call Spread

bear-call-spread

1. Definition

The Bear Call Spread, also known as Short Call Spread or Call Credit Spread, is widely known as “downward blockage”, and it is a strategy to take advantage of sucessive drops on the underlying assets’ prices. This strategy comprises selling an ATM Call at a certain price and buying an OTM Call at higher prices, but with same expiration dates.

Selling a Call At-The-Money: selling a Call with strike prices as close as possible to the current share prices. Selling a Call forces you to sell a share until the expiry date, for the strike price.

Buying a Call Out-The-Money: buying a Call at prices above the share prices. Buying a Call gives you the right of buying a share until the expiry date, for an established price.


2. Objective

Earning from a shrinking market, or a neutral market. However, this strategy has a safeguard if prices contradict the expectations and move up. This generates limited gains from falling markets, and limited losses if the market moves up. It’s widely use as a conservative strategy, for market in which forecasts are confused.


3. How it works

In this strategy, an ATM Call is sold, receiving a premium. At the same time an OTM Call is purchsed at a higher strike, paying a premium. The initial balance for the operation is positive, with premiums received exceeding those paid. The graphs result as follows:

Selling a Call + Buying a Call = Bear Call Spread

Selling a Call

gráfico Short call_clean

+

Buying a Call

 gráfico Long call_clean

=

Bear Call Spread

gráfico Bear Call Spread_clean

Caption:

Red = Losses

Yellow = Losses from premiums paid

Green = Profits

Earnings: gains are always limited with their maximum being reached when share prices are equal or lower than the strike for the ATM Call sold. The max gains is the balance between the premiums received and those paid.

Losses: losses are alos limited, and their maximum happens when share prices exceed the OTM Call strike. Maximum losses are equal to the difference between both strike prices minus the premiums balance.


4. Example

Consider the following data:

Asset

Petrobrás

Date

09/10/2013

Maturity

10/21/2013

Share prices

18,94

Days before expiration

41

Number of options

1.000

To set up this operation, the investor needs to sell a Call At-The-Money PETRJ19 earning a premium of R$ 1.00 per option and buy a Call Out-The-Money PETRJ20, paying a premium of R$ 0.27 each.

Summary:

Type of Option

Asset

Series

Number of options

Premium

Strike

Liquidation

Selling a Call

Petrobrás

PETRJ19

1.000

1,00

19

1.000

Buying a Call

Petrobrás

PETRJ20

-1.000

0,27

20

-270

Total

0,73

730

By the expiration date, results depend on the share prices as follows:

Prices by expiry date

Selling a Call

Buying a Call

Results

R$ 13,00

1.000,00

-270

730

R$ 14,00

1.000,00

-270

730

R$ 15,00

1.000,00

-270

730

R$ 16,00

1.000,00

-270

730

R$ 17,00

1.000,00

-270

730

R$ 18,00

1.000,00

-270

730

R$ 19,00

1.000,00

-270

730

R$ 20,00

0,00

-270

-270

R$ 21,00

-1.000,00

730

-270

R$ 22,00

-2.000,00

1.730

-270

R$ 23,00

-3.000,00

2.730

-270

R$ 24,00

-4.000,00

3.730

-270

Results:

If Petrobras shares reach the range between R$ 19.00 and R$ 20.00, the investor will be exercised and forced to sell shares at R$ 19.00, but won’t be exercising his rights of buying shares at R$ 20,00. Results accumulate R$ 1.00 losses per option. However, as he received a premium of R$ 0.73 per option, net losses reach R$ 0.27 per option. If shares stand below R$ 19.00, no options will be exercised, and the maximum profits of R$ 0.73 per option can be achieved. Look the graph below:

gráfico Bear Call Spread_pronto

Caption:

Red = Losses

Yellow = Losses from premiums paid

Green = Profits

Earnings: the operation generates profits if Petrobras shares are lower than R$ 19.73 (Prices + Premiums), so he will be exercised to sell shares at R$ 19.00, obtaining a compensation of R$ 0.73 in premiums. So, if shares are lower than R$ 19.73, results are positive. The maximum gain of the transaction will be R$ 730.00, when the Petrobras shares at maturity is below R$ 19.00, which is the exact amount of premium received on the sale of ATM Call minus the premium paid in the purchase of Calls OTM.

Losses: the investor accumulates losses if Petrobras shares exceed R$ 19.73, with maximum losses of R$ 270.00. Between R$ 19.73 and R$ 20.00, the investor will have loss, but this loss will be reduced, according to the premium paid. The more expensive the premium paid by ATM Calls, will be worse. As in this case the premium paid was R$ 0.27, it will prejudice because of this premium, as the share price is within the range of R$ 19.73 to R$ 20.00.

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