A Bear Call spread is a hedged risk options strategy created by buying an OTM(Out of The Money) call option and selling an ATM (At The Money) call option.
This strategy is useful when you are bearish on the market, so you would want to benefit from a falling market price by selling a Call option of a strike of the spot price or near to spot price. However, to hedge against the opposite movement of the market, you could buy a Call option of the higher strike. This would cap your losses to the difference between premiums of lower strike and higher strike.
Risk vs Reward
Let us consider the example of 24 AUG expiry when the spot for NIFTY is 19393. We can create a Bear Call spread by selling a Call option at the 19400 strike (trading at 57.5) while buying one at the 19600 strike (trading at 7).
This would create a Bear Call spread with a maximum potential profit of 2525 and a maximum loss of 7475.
Calculating profit
Maximum profit for this strategy would occur when Nifty is lower than 19400. Let us see how the profits are calculated for this strategy.
If the position is short then the amount is negative or loss, while if the position is long then the amount is positive or profit. However this is applicable only when options expire (ITM) In The Money, the profit loss for the OTM (Out of The Money) option always amounts to the premium paid.
Assuming NIFTY is trading at 19300 at expiry. Since both options expire out of money, they would be worthless at expiry, so the profit/loss of the option would be equal to the premium paid or received.
Profit on short 19700 CE = ( 57.5 ) * 50 = 2875 ( short position)
Loss on long 19600 CE = (-7 ) * 50 = -350
Net maximum profit for strategy = 2875-350 = 2525
Calculating Loss
Maximum loss for this strategy would occur when Nifty is higher than 19600. Assuming Nifty is trading at 19700 at expiry.
The profit/loss for any option position is calculated at ( spot – strike – premium ) * lot size.
Loss on short 19700 CE = ( 19700 – 19400 – 57.5 ) * 50 = -12125 ( short position)
Profit of long 19600 CE = ( 19700 – 19600 – 7 ) * 50 = 4650
Net maximum loss for strategy = -12125 + 4650
The important thing to note is that beyond 19600 the loss is going to be constant, as whatever you lose in the short position, you would gain in the long position. Hence this is considered a safe strategy as it is hedged on both sides.
Risk to Rewards Ratio
The margin required for this strategy is very low compared to selling naked options without a hedge. The margin required is only 28634, which makes out ROI 2525/28634 = 9% while our loss would be -7575/28634 = 26%.
This would make it a 3:1 risk-to-reward ratio. You can adjust the distance between the two legs to change the risk-to-rewards ratio, but it would also change the probability of profit and the maximum profits and loss. The closer the two legs are the lesser the maximum loss would be, hence a better risk-to-rewards ratio.
When to use this strategy
This strategy is useful when you are reasonably sure that the market is going to move lower near the expiry. This strategy is also useful when you are starting with your options journey and have relatively lower capital. This strategy also provides hedging benefits there as the losses are always limited, so you would not lose all your capital even if market goes against your position.
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