Vertical spreads offer an option trader a wide variety of risk/reward scenarios. There are always tradeoffs when it comes to options and the different strategies that can be used, and vertical spreads are no different. If the risk outweighs the reward, the chances are better for profit. If the potential profit outweighs the risk, it is going to be harder to profit.
 
Many option traders tend to stay away from credit spreads or trade them too much. Debit spreads (depending on how they are implemented) usually offer higher rewards based on the risk amount and are often viewed as a “safer” choice and easier to understand. Once option traders understand credit spreads, many prefer them over debit spreads. Let’s take a look below at some bearish vertical spreads and some of the points option traders need to reference.

Benefits

One of the nice things about credit spreads is they can profit if the underlying doesn't move much or it moves in the intended direction. A debit spread, such as a bear put spread, often needs the underlying to fall to profit from the spread.
 
A bear call spread involves selling a call option while purchasing a higher strike call option with the same expiration. The short call option is more expensive than the long call option. Adding a long call option to the short call position creates a credit spread and protects the position from further losses if the underlying rallies past the two strikes. This credit spread has a smaller potential profit than a naked call option but also limits risk. 

Let’s look at an example.

Netflix Inc. (NFLX) was trading at around $367 recently. After trading sideways for a couple of months, the stock hit a recent high and then pulled back several days.  A trader might assess that this resistance (from a recent high) could be a difficult area for the stock to rise above even with the recent move lower. He or she could, thus, try to capitalize from this forecast by trading a bear call spread.
 
Here the trader would sell a call even a little higher than potential resistance at $380 and buy a higher-strike call for protection, thus creating the spread. 

Decisions

With a bear call spread, choosing strikes that are farther away from the current price with the same strike distance, usually means the less the credit that will be received on the spread. For example, if the current stock price is $367, a 380/385 bear call spread should generate a larger credit than a 385/390 bear call spread. The credit received is the maximum profit that can be attained. So, with a bear call spread, there exists a natural tradeoff of chances of success vs. payout structure. The higher the short strike, the safer; the lower, the greater profit potential.

How to Implement

In the above example, the trader decides to sell a 380/385 May-03 (just over a week till expiration) bear call spread as follows: Sell the May-03 380 call for a credit of 2.10 and buy a May-03 call for a debit of 1.30. The total credit on the spread is 0.80. If NFLX finishes at or under $380 by May-03 expiration, the spread would expire worthless and the trader would keep the credit. The maximum at risk on the trade is the difference in the strike prices minus the credit received, which in this case is 4.20 (5 – 0.80). The breakeven point is $380.80 (380 + 0.80), which is derived from adding the credit to the short call.

Final Word

When choosing whether to do a bear call or a bear put, a trader also has to take into account his or her trading personality. Just because one spread may seem advantageous over another doesn’t mean it should necessarily be implemented. Some option traders cannot bear the thought of taking a maximum loss on a credit spread like the bear call and have trouble sleeping at night worrying about it. But if that is not a major concern for you as a trader, remember that depending on how it is implemented, a bear call spread may offer a lower profit potential but offers more of a chance to profit as well.

John Kmiecik, Market Taker Mentoring