Some Option Trades Generate Income Immediately, With Minimal Risk

Dec 31, 2009
James Brumley

Option traders don’t have to settle for buying low and selling high to generate a profit when a trade is closed out, as is the normal Wall Street strategy. Instead, certain types of spread trades can generate immediate income. Some of these positions can even profit from bearish/falling stocks or indices.

What kind of option trade does this? A ‘bear call credit spread’… a type of option trade that generates net income at the onset of the trade, and if things go as planned, allows the trader to keep all those net proceeds until the options expire.

A Bear Call Credit Spread Explained

Though the name ‘bear call credit spread’ may be daunting, it’s actually a pretty accurate description of this fairly simple trade. Here’s why it’s called what it’s called:

• Bear: The stance is a bearish one – the trader thinks the stock is going lower, or will do no better than remain flat through the end of the trade
• Call: Call options are used to take on the position, as opposed to put options
• Credit: The trade generates net income when the trade is initiated, as opposed to most other trades which start with a cash outlay, or debit
• Spread: The trade takes a stance between two strike prices; the ‘spread’ is the difference between the two

As for what they’re designed to do, like the name implies, bear call credit spreads seek to generate income on bearish charts. The ‘spread’ aspect may limit the total income, but it also limits the total risk. The income is generated when one of the call options is sold for a greater price than the price at which the other call option is bought. The net difference becomes the ‘credit’… but it’s not risk-free.

An example will illustrate the strategy in more detail.

Example of a Bear Call Credit Spread Option Trade

Suppose XYZ stock is trading at $82.45, and a trader felt this stock was going to go lower… or do no better than simply not move higher. And, also suppose the same trader wanted to generate some income right away on the outlook. At the same time, assume the trader wanted something of an ‘insurance’ policy to cap the potential loss on the trade. A bear call credit spread could meet all three needs.

Option trades such as this are really two complementing option trades. One call contract is bought at a small price, and another is sold at a higher price. In the case of a bear call credit spread, both option’s strike prices are going to be above the stock’s current price.

In the hypothetical case of XYZ, this means the trader would be looking to short the next month’s (as a rule of thumb, credit spread trades rarely use options that expire more than two months out) 85 calls, and buy the next month’s 90 calls. Assuming average volatility, the 85 call could be shorted at a price of $310 per contract, while the 90 call would only cost $160 per contract. If the trader issues both trades, the difference of $150 per contract is pocketed.

From then, the trader simply waits and hopes that XYZ shares don’t move above $85 by the time the options expire. If the stock doesn’t move higher or moves lower, that $150 is simply retained, and the two options simply cease to exist by the next month’s expiration….wiping away the risk.

Risks of Bear Call Credit Spread Option Trades

Bear call credit spreads are no free lunch – the risk of XYZ shares moving above the strike price of the shorted call option is a direct risk to the option trade’s initial credit/profit.

How so? If XYZ stock appreciates in value to, say $86.60 per share before the option expires, that 85 call is ‘in the money’ by $1.60…. and the trader on the other side of the table that owns the call that the spread trader shorted will almost certainly want to exercise it. If that happens, the writer/owner of the bear call credit spread will be forced to buy 100 shares of XYZ (remember, 1 option contract = 100 shares) at $86.60 each, and then turn around and deliver them to the contract’s owner at a price of $85.00 each, at the contract’s strike price. That will result in a net loss of $160 for that transaction, and more than eat into the trade’s initial gain of $150…. a $10 loss.

The good news/bad news is, there is a cap on the total loss the trade could incur…. of $350. That would be the end result if XYZ exceeded $90 per share. At that point, the long 90 call could also be exercised, buying shares at $90 each, and then delivering them at $85 each – a $500 difference, when calculated for a 100 share lot. The initial $150 credit at least partially offsets that loss though.

Bear Call Credit Spread Tips

• Small losses should never be allowed to become big losses
• Most problems can be avoided by choosing the right stock before the trade is entered
• ‘Paper trading’ a few of these spreads is recommended before committing real capital to them.

Suggested Reading

What is a Covered Call Option Trade?

The Web’s Best Free Option Trading Calculators

Influences on a Stock Option’s Value