A vertical bear call spread, as the name suggests, is a vertical call spread which consists of two calls at different strike prices. The lower strike price remains of the short call while a higher strike price is set for long call. This strategy works best for bearish markets and ensures net cash inflow with a lower risk.
It acts as an ideal play when the amount of fall for the underlying asset between the trade and expiry date can be predicted. A higher fall ensures better profits for a bear call spread.
Let us understand how a vertical bear call works with an example:
If you buy an underlying security whose Nifty spot is Rs3,222, the vertical bear setup will be:
- Buy 3400 Call (CE) by paying a premium of Rs 40, which is an On the Money (OTM) option.
- Call 3100 Call (CE) by paying a premium of Rs130, which is an In the Money (ITM) option.
Hence, the net cash flow is Rs130 – 40 = Rs90, which is positive and signifies a net credit in the account.
- If the expiry is at 3500 (above long call)
Both of the calls will have an intrinsic value and would expire In The Money.
- 3400 CE has an intrinsic value of Rs100, hence the profit will be Rs 100 - 40 = Rs60
- 3100 CE has an intrinsic value of Rs400, hence the loss will be Rs - 400 + 130 = - Rs270
- Net loss would be Rs – 270 + 60 = Rs 210
- If the expiry is at 3400 (at long call)
3100 CE will have an intrinsic value and expires in the money.
- 3400 CE expires worthless, thus premium of Rs40 is loss.
- 3100 CE has an intrinsic value of Rs300, hence the loss will be Rs - 300 + 130 = - Rs170
- Net loss would be Rs – 170 – 40 = Rs 210
- If expiry is at 3190 (Breakeven)
It is a no profit no loss situation and hence is called as breakeven point.
- 3400 CE would expire worthless, thus a premium of Rs40 is loss.
- 3100 CE would expire at 90, thus premium retained (profit) will be Rs130 – 90 = Rs40
- Net loss would be Rs40 – 40 = 0 (no profit no loss)
- If market expires at 3100 (at short call)
- 3400 CE expires worthless, so premium of Rs40 is loss.
- 3100 CE has no intrinsic value, hence will retain premium of Rs130.
-Net profit = Rs130 – 40 = Rs90
- If market expires at 3000 (below short call)
At 3000 both will expire worthless.
- 3400 CE expires worthless, so premium of Rs40 is loss.
- 3100 CE expires worthless, hence will retain premium of Rs130.
- Net profit = Rs130 – 40 = Rs90
Here are the insights of the bear spread,
- Spread = Difference between strikes = Rs3,400 – Rs3,100 = Rs300
- Net credit = Premium received – Premium paid = Rs130 – 40 = Rs90
- Breakeven = Rs3100 + 90 = Rs3,190
- Max profit is net credit
- Max loss = spread – net credit = Rs300 – 90 = Rs210
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