How to Calculate Risk Quickly on a Bear Call Spread
January 21st, 2010 | 
Author: So I was definitely one of the nerdy kids in math class. I loved calculating things and figuring out how numbers add up. Out of sheer boredom this afternoon, I decided I’d take my conceptual ideas for calculating risk in a bear call spread and put them into writing to help other people quickly figure out what their potential risk is in an options trade. Here’s what the man cave drawing board looked like after I was done:
Side note: if you don’t have a drawing board in your trading room, GET ONE! It will help you produce ideas and keep you on track with your goals very well. Anyways, as I was saying, this was basically how I calculated my risk in this options trade. Quite simply, here’s the final result of all that garbage:
Risk=(o*d)-c
o=Number of options traded
d=Distance between your two strike prices
c=Initial credit for purchasing the spread
So if you are trading 15 contracts on a vertical at 114 and 116 for your strike prices with an initial credit of 47 dollars per contract, what’s your total risk? Let’s calculate it real quick:
Risk=(1500*2)-755=$2245
Yikes! If you’re wrong about this trade you could lose over 2 grand! Just keep in mind, every time you widen your spread in a bear call spread options trade, you increase your risk tremendously. So play it safe in this options strategy and keep the strike prices as close together as possible.
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I think what’s important to remember is that a vertical spread 9like the one mentioned above) is analagous to selling naked options with an insurance policy attached. You could easily make more money if you didn’t have to buy the higher strike price option (the “insurance”) but you would be exposing yourself to potentially unlimited risk.
For example, say you sell a naked call instead of a vertical spread. Overnight, the underlying stock gaps up 10 points. Your stop loss automatically buys back to cover the next morning. You immediately and automatically lose $9000 ($10,000 minus your initial credit of roughly $1000). Bet you wish you would’ve sold a vertical spread with only $2245 in risk!
There is one other advantage to vertical spreads: “set it and forget it”. This principle alone can save an emotional trader from their portfolio killing things-are-bad-now-but-I-swear-they’re-are-going-to-turn-around-soon mentality.
Plus, with a vertical spread you don’t need a stop loss. The call you sell can swing deep into the money without forcing you out of the trade. Instead of getting pushed out automatically at the first sign of trouble, you can hold hope that the underlying price will swing back and your short call will become out of the money again by expiration friday.
So while vertical spreads can seem like low profit, high risk trades, there are a ton of great reasons to pay attention to them.
“So while vertical spreads can seem like low profit, high risk trades, there are a ton of great reasons to pay attention to them.”
I would have to take issue with this assumption. Vertical spreads like the bear call spread really aren’t high risk at all, even though they do have a pretty intimidating risk to reward ratio. They actually have around a 70 percent chance of success given the fact that they don’t have to predict the movement of an underlying, just one direction in which it will will not go.
I’m not sure if that was the point you were trying to make, but either way, this is probably one of the most high probability trades you can place in options. If anyone is still confused about it, might want to read up on vertical spreads by clicking here.