Josip Causic

Bear Call Spreads Gone Bad

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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.

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

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

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.

Bottom line = -0.045 cents

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