The figure below shows the risk/reward graph for a Bear Call Credit Spread on the Russell 2000 index (RUT). This type of trade is called a credit spread because when we, as a seller, open, or sell, this type of trade, we will collect a credit, also called a premium. When this trade expires, and if the RUT stays below the 740 strike price, the credit spread will expire worthless for the buyer, and we as the seller will keep the premium collected, which is about $500 for the trade shown below. In order to create this Bear Call Spread we would open the following two “legs” shown below:
Buy to open, RUT 10 contracts, 750 strike, January 2006 Call
Sell to open, RUT 10 contracts, 740 strike, January 2006 Call
Buy 10, RUT 750 Jan 06 Call
Sell 10, RUT 740 Jan 06 Call
10 RUT Jan 740/750 Bear Call Spread
Dissecting the name “bear call credit spread”, “Bear” denotes that we want the underlying RUT index to remain below 740, our short Call that we are selling, or writing. “Call” denotes that the trade is made up of Call options. “Credit” denotes that we are collecting a net credit (premium) and depositing the funds into our brokerage account upon opening the spread. The credit is the difference between the 740 Call that we sold, less the 750 call that we purchased. Because the 740 Call is closer to the underlying RUT index, it’s worth more than the 750 call, thus the reason that we end up with a net credit. “Spread” denotes that we are opening two legs – buying a Call at one strike price, and selling a Call at different strike price, but both in the same expiration month. In this case, we are selling the 740 Call and then we’re buying the 750 call for protection to limit our risk. The 740/750 Bear Call Spread is a “10 point” spread…i.e. 10 points between the buy leg and the sell leg.
This risk/reward graph shows the Russell 2000 Index (RUT) on the left, (Y axis on left is the price of the RUT index) and a graph of the bear call spread option trade on the right. The X axis on the bottom right is the gain or loss of the trade in dollars.
When this trade expires in 55 days, and if the RUT stays below 740, the credit spread will expire worthless for the “buyer”, and we the “seller” of this spread would keep the premium of about $500. If the RUT starts to climb into the 740 strike, we then would make adjustments. A few adjustment strategies are covered in this Learning Center.
For this particular credit spread, we the seller would need to lock-up $10,000 in maintenance in our brokerage account to open the trade, and these dollars would be unlocked when the spread is closed. Our total risk capital to open these 10 credit spreads is the $10k of required maintenance, less $500 in premium that we collected when first opening the trade, or $9500. In order to calculate a simple return on investment (ROI) one would divide the premium collected by the total risk capital, which is 500/9500 = 6%.