Bear Call Spread On AMC
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Options provide a large degree of flexibility and can provide traders with a strong advantage when faced with varying market conditions. One particular strategy, the Bear Call Spread, is a strategy where a trader can profit from both sidewards and downward movement. This article will cover the key topics of how and when to apply a Bear Call Spread using a real example from our market.
These key topics are:
- What a Bear Call Spread is
- When to apply the strategy
- How to construct the strategy
- How to calculate risk and reward
If you would like to watch a video on how a bear call spread works, please click here
What a Bear Call Spread is:
A Bear Call Spread is a “credit spread” which means you receive a credit upon entering the trade. Subsequently, if you want to close this trade, you will have to pay to exit. The idea is to pay less that what you receive.
Options have time value which erodes as expiry approaches. The Bear Call spread can benefit from time decay, as we want our options to erode in value and therefore pay as little as possible when exiting the trade.
When to use a Bear Call spread:
A Bear Call Spread can be suitable if you have a bearish or bearish to sidewards view of the market.
For example, looking at the AMC chart, you can see the stock has tracked sidewards since late 2016, trading within a channel pattern.
Since the beginning of March, AMC has risen steeply to the top of its trading range of approximately $15.50. It failed to push through the resistance, confirming the channel pattern and as a result fallen to provide a suitable entry signal for a Bear Call Spread.
This setup is ideal for implementing a Bear Call Spread as we can place the majority of our risk at or above the $15.50 resistance level, whilst still receiving a suitable premium. Ultimately, to do this trade, you would expect AMC to continue to fall and continue trading within the channel.
How to construct the strategy:
A Bear Call Spread involves buying and selling calls simultaneously as a combination order, with the bought call above the sold call. One way to construct this trade is to place both “legs” above the share price, and if possible, above a strong resistance level.
For example, AMP’s share price is $15.20, and resistance is at approximately $15.50.
Below is an example of constructing a Bear Call spread on AMP:
- The Bought Call is $16.50
- The Sold Call is $15.50
- The Credit is 21 Cents
As the image shows, both the sold and bought calls are placed above the current share price, with the sold call also being resistance.
How to calculate risk and reward
The maximum profit of a Bear Call Spread is the credit that is originally received upon entering the trade, minus any transaction costs.
The maximum risk of the trade is calculated by taking the difference between the bought and sold calls (a.k.a “the spread”), minus the credit received upon entry.
Using the AMC example:
- The maximum profit is 21 cents (minus any transaction costs)
- This 26.66% of total risk.
- The maximum risk is 79 cents:
- $16.50 - $15.50 = $1.00
- $1.00 – 21 cents = 79 cents
Maximum profit is realised if the share price is below the sold call of $15.50 on expiry.
Maximum loss is realised if the share price is above the bought call of $16.50 on expiry.
If this occurs, both the bought and sold call will expire worthless. This means the trade will cease to exist and will not have to be closed out, saving on exit costs like brokerage.
Bear Call Spread benefits:
There are several key reasons traders might use this strategy:
It is a strategy which can profit from a falling and/ or sidewards market, where the risk is only if the market rises.
In the AMC example, The Bear Call Spread benefits from simply time passing by and can result in taking maximum profit, as long as the stock is below $15.50 on expiry. In addition, if AMC were to fall, an early opportunity would also arise to close for a strong profit.
The Bear Call Spread is a credit spread, and on the Australian market you can use certain stocks to cover margin on credit spread. This often makes the Bear Call Spread an attractive strategy for increasing yield on a share portfolio.
Options are a highly flexible tool which a trader can harness to capitalise on any view they hold on the market. The Bear Call Spread is but one example of a strategy that an option trader has in their arsenal, to take advantage of any market condition.
If you would like to further understand how to implement a bear call spread, you can watch a short video buy clicking here
If you would like to construct a Bear Call spread yourself and practise other options strategies, you can register to use the options calculator here
TradersCircle is one of Australia's leading stock market education firms, and runs one of the country's busiest options trading desks. Learn more at www.traderscircle.com.au.