When you believe a stock will go down, Bear Call (Credit)  Spreads are a low risk, limited reward strategy.   Bear Call Spreads are generally "Out Of The Money" trades.  A Bear Credit Spread can also be put on at, or in the money, which essentially increases both the risk and the potential profit.

In a Bear Call Spread, you sell a certain number of option contracts on a stock at a certain strike price. Then, you buy the same number of option contracts (with the same expiration date and on the same stock) at a slightly higher strike price.

You end up creating a net credit that is distributed to your account, less commissions, the following day.  This net credit is your maximum profit. 

The margin required to put on a Bear Credit Spread is the difference in strike price between the two legs of the spread, times the number of contracts, times 100.  The cash received when the trade is made is applied toward the margin requirements

Cash Required = ([Higher Strike Price] - [Lower Strike Price]) x Number of Contracts x 100

As an example lets suppose we were bearish on Hotels.com (ROOM).  ROOM is trading at 58.50,  To initiate the trade we sell 5 January $60 calls at $1.60, and buy 5 January $65 calls at $.25.  This results in a net credit of $675 to our account.  Margin requirements are calculated as follows:

Cash Required = ([Higher Strike Price] - [Lower Strike Price]) x Number of Contracts x 100

Cash required = (65 - 60) x 5 x100

Cash required = 5 x 5 x100 = $2500

Since the trade created a net credit of $675, we must have an additional $1,825 in our account, after paying commissions, to cover the margin requirements. 

Ideally, the stock will stay below the strike price of both calls by any amount, and they will both expire worthless.  This allows us our maximum profit, with the added benefit that we need not pay commissions to close out the trade.

Conversely, our maximum loss occurs when the stock is at or above the higher strike price on expiration day, as the call we bought will cover in profits the losses on the calls we sold, dollar for dollar, once this point is reached.  In this case, we must closeout both positions by expiration day, or our (in the money) options will be exercised. 

The chart below shows the costs to make this trade and the status of our trade on options expiration day.

(Graph courtesy of optionsXpress)

Of course, barring a huge gap up, we would exit this trade well before our maximum loss is reached if the trade goes against us.  Bear Credit Spreads are usually placed in the last few weeks before options expiration day because the decrease in the time value of the option, as the expiration date nears, works in our favor.

There are a number of things to keep in mind if you want to trade Bear Credit Spreads.  Among them:

1) You must be approved by your broker to trade credit spreads.

2) You must close out "in the money" positions by expiration day or they will be exercised.  In fact, any in the money option position may be exercised at any time.  Although options are rarely exercised before expiration day, it can happen.  This is a disadvantage of "at the money" and "in the money" Bear Credit Spreads.

3) The number of trades you can make in any month is limited by your available cash due to the margin requirements.

4) You will likely have to pay commissions on both legs of the spread.

Discussion

Essentially, the Bear Credit Spread is very similar to selling naked calls.  The difference is that buying the further out of the money call protects both you, and your broker from a catastrophic event.

There is a point at which you will breakeven on a spread trade if the stock closes exactly at this level on options expiration day (the 3rd Friday of the month).

You calculate the breakeven point by adding the amount of net credit you made, from the lower strike price call (in the case of a bear call spread).

In the example above, we bought the $65 call and sold the $60 call to make $1.35 in net credit. You then add $1.35 to $60 to get $61.35. This is your breakeven point on expiration day because the $65 put will expire worthless, and you will closeout your position by buying back the $60 put for $1.35 (the amount it is in the money.)

There are a number of ways to exit (or unwind) a Bear Credit trade.  As we stated earlier, ideally both legs of the spread will expire worthless on expiration date, and you'll do nothing.

Also keep in mind that if the stock moves substantially lower at any time during the trade, but especially near its inception, it may be to your advantage to buyback the option which you sold, for a significantly lower price, and lock in a quick profit.  You would then hold the call that you bought, since there is a chance (although small) that the stock might rise and make that option profitable.

The greatest risk from this trade occurs near its inception.  As a rule of thumb, the first level you should consider closing out the trade for an out of the money Bear Credit Spread is if the stock rises to the strike price of the lower priced call (that you sold).  This eliminates the risk, miniscule though it may be, of the option moving into the money and being prematurely exercised.

Another standard stop strategy to set your stop at twice the credit initially received.  In other words, you risk the amount of the credit.

If it is late in the trade, you may decide to partially unwind the trade by just buying back the lower priced call that you sold.  As expiration day approaches, this call declines in (time) value, so you can buy it back for less than you paid for it and conceivably show a profit, even if the trade eventually goes against you.

Another way to close out a trade is to use a simple stop strategy.  In other words, again using the above example, we made a net credit of $1.35 per contract when we put on the trade.  When the trade reaches a point where it would cost us $2.35 per contract to close it out, we then have a loss of $1 per contract.  This becomes our stop.  The stop is reached when the price to buy back the call we initially sold, less the income from selling call we initially bought, reaches $2.35.

One major advantage of an out of the money credit spread is that it starts out profitably (with a credit), and the way you structure a trade can often allow you a pretty nice buffer zone before your profit gets threatened.

Finally, you can structure a credit spread to be as conservative, or as aggressive (risky) as you wish.  Conservative credit spreads are put on well out of the money about 30 days before expiration.  Aggressive credit spreads are put on no more than 60 days prior to expiration, and may be at or in the money.

It is imperative that, if an in the money option gets exercised prematurely, you cover it immediately.  In all honesty, I have never had that happen, even with options that were well in the money, put it is a possibility you should be aware of.

The obvious question at this point is:

When do you use a Credit Spread, and when do you use a Debit Spread?

The answer is pretty straightforward.  Credit spreads depend on the underlying instrument moving in the direction or your trade, or not moving at all.  You start out at a credit, and all the underlying must do is stay in the vicinity where you made the trade for the trade to be profitable.  This is a good strategy for flat, choppy, and non-trending markets.

The debit spread has the effect of giving you a net option that is cheaper, and slower moving (a net lower Delta) then if you just bought an option alone.  Since you start out at a debit, you require significant movement for the spread to become profitable.  The combination changes in value slower than a simple option buy, protecting you (to some degree) from whipsaws.  Debit spreads work best in fast, volatile, trending markets.

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