Calling All Bears

By Ken Trester

The phrase "call option" makes most investors think of a stock on the rise, which, of course, is almost always correct -- but bear-call spreads provide an exception.

As the "bear" part of the name implies, a bear-call spread is a great option strategy to use when you expect that the underlying stock, index or commodity will decline in price.

So how does the "call" work with that?

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A bear-call spread works by selling call options at a particular strike price while also purchasing an equal number of calls at a higher strike price as a hedge in the same transaction.

The good news is that this strategy is fairly conservative and you collect premium at the time you make the trade. (This strategy is also called a call credit spread.)

However, because you collect money at the outset of the trade, bear-call spreads cap your profit potential: Your maximum return equals the difference between what you pay for the long option versus what you collect on the short option. (Of course, you want to collect more on the short option than you pay for the long option, which is what makes this a credit spread.)

Essentially, in a bear-call spread, the value of the spread goes up as the stock goes down, and you receive a credit for initiating this trade. You incur a debit for the long position (that you Buy to Open) and receive a credit for the position you write (or Sell to Open), so you pocket the maximum profitability right away. Your goal is to keep the premium upon the spread's expiration.

Why would you go with a spread strategy and not outright Sell to Open the lower-strike call for a bigger initial payout?

When you buy the call options (or even the stock) to hold long against the short call position, you're protected in case the trade doesn't go in your favor.

How?