Bear Call Spreads Gone Bad

This article originally appeared on The Options Insider Web site.

In this article, I will go over three possible outcomes for a bear call spread at expiry. Those scenarios involve the price of the underlying closing within the spread, above the sold call, and below the sold call.

A student of mine e-mailed me pleading with me to explain to him a trade in which the student has gotten into without knowing much about spread trading.

From the e-mail, it could be inferred that the student has taken a bigger position from what is normal. Without disclosing anything about the student, I will go over the facts of the trade.

I have included the chart here, as I usually do for my real trades, but I choose to white out the exact ticker. Thus, when referencing the underlying, I will use that worn out clich� of XYZ.

The daily chart of XYZ below shows (with a blue oval) the point of the initial entry. I have also marked on the chart in green letters the words, “Long Entry.” It is at this point that the student went long.

In hindsight, we could observe that from the technical analysis view point, the XYZ at the time of the entry was coming to a resistance, yet that was the exact place where the student went long.

See full-sized chart.

Breaking Down the Trade

I was told in the e-mail that the initial trade on XYZ involved going long on a March 14 call, while XYZ was hitting resistance, as I pointed out above. At that time, the premium for the calls was high, but as soon as XYZ started to head south (way south), the call premium got cheaper.

The next point, marked on the chart with a dark blue oval and the word “Spread,” is where the student added more contracts to the existing position, and then turned it into a spread trade.

This action of averaging down is something that we, the instructors at Online Trading Academy, strongly discourage, for even if it works out occasionally, the strategy creates a bad habit that is difficult to break later on.

The final outcome of turning it into a bear call has produced the following trade:

BTO + 100 March 14 Call @ -0.505 (OTM)
STO � 100 March 13 Call @ + 0.70 (ATM)
Max Profit (is the difference) + 0.195
Max Loss (width Spread 14c-13c) 1.00 � Max P
Max L -0.805
ROI = Max P/Max L = .195/.805 = 24.2 %
Breakeven Point (BEP) = sold strike + Max P = 13.00 + 0.195
BEP = 13.195

Oddly enough, the moment the student had turned his initially bullish trade into a bearish trade, the market had reversed and started rallying up.

The trader was now sitting in a trade that he completely did not understand. Moreover, due to the huge contract size, the broker had placed the maintenance on his existing position, in this case $10,000. This is a huge chunk of change to be sitting unused.

Having presented all the facts, let us go over three possible outcomes that could take place at the expiry.

Three outcomes	XYZ price @ Expiry	Outcomes
Scenario 1	Below the sold call	Good = Max P (profit)
Scenario 2	Above the sold call	Bad = Max L (loss)
Scenario 3	Within the spread	Depends

I hate oversimplifications, but often when explaining something it is useful to use them as a starting point. Now let us turn our attention to each of those three scenarios and dig a bit deeper into them.

Scenario # 1 (Good outcome) XYZ $13.96

Strike Price	Premium Cost	Stock @ expiry	Call Value @ expiry	P/L (profit/loss)
+ 14c	- 0.505	13.96	0	- 0.505
- 13c	+ 0.70	13.96	0	+ 0.70

Bottom line = +0.195 cents

The best possible outcome, keeping the maximum profit (Max P) or 0.195 cents and the maintenance on our account is lifted after the expiry.

Scenario # 2 (Bad outcome) XYZ $14.90

Strike Price	Premium Cost	Stock @ expiry	Call Value @ expiry	P/L (profit/loss)
+ 14c	- 0.505	14.90	+ 0.90	+ 0.395
- 13c	+ 0.70	14.90	- 1.90	- 1.20

Bottom line = -0.805 cents

With the price being at $14.90, the sold 13 call is now worth $1.90, and it needs to be repurchased for a much higher price than what was sold. Observe that it was sold for 70 cents and now needs to be bought back for $1.90. In this case, the loss is $1.20 per contract.

However, the trade has gone sour, yet the max loss isn’t $1.20 because of the fact that the 14 call, which was bought for 0.505 cents and is now trading for 0.90 cents; so once the 14 call is sold, the profit of 0.395 cents is received and needs to be subtracted from the $1.20 loss (caused by the sale of the strike price of the 13 call). Therefore, the loss is actually 0.805 cents.

Strike Price	Premium Cost	Stock @ expiry	Call Value @ expiry	P/L (profit/loss)
+ 14c	- 0.505	13.24	0	- 0.505
- 13c	+ 0.70	13.24	- 0.24	+ 0.46

Bottom line = -0.045 cents

When all the calculations are done, the loss is basically less than a nickel per contract.

The reason why that would be the case is the following: The breakeven point (BEP) was $13.195 and the price has closed at $13.24, when the bigger number is subtracted from the smaller one (the closing price minus the BEP) or $13.24 – $13.195, we get the loss of only 0.045 cents; which is small.

Now, keep in mind that one contract controls 100 shares, and the student has 100 contracts, which is basically 10,000 shares. This means that the loss, which seems small, is in fact $450 plus the commissions. Once again, be aware of the position sizing when trading options.

Leverage is a two way street — it can work for you or against you.

As the saying goes, “Wise trader learns from his or her mistakes, but the wiser one also learns from the mistakes of the other traders.”

Please do not look down on other fellow traders; learn from their mistakes. Even if you lose money on the trade, do not lose the valuable lesson that the trade had. Go over your bad trades and learn from them. It is painful but it is worth it.

Good trading and, again, watch your position sizing.

Josip Cusic is an instructor with the Online Trading Academy. To learn more about him, read his bio here

This article originally appeared on The Options Insider Web site.