A Goldilocks’ Bear Call Spread

Richard Croft
June 10, 2013
9 minutes read

The US Jobs report that was released on Friday painted an almost perfect goldilocks scenario. Something for everyone!

Enough new jobs were created to support the thesis that the US economy is growing, albeit at a tepid pace. At the same time, the unemployment rate rose from 7.5% to 7.6% as more people entered the labour force. That unemployment data could be taken one of two ways; the increase in unemployment virtually assures the market that the US Federal Reserve will continue with their quantitative easing… good for the market! It could also be a sign of an improving economy, which has encouraged more people to get off the sidelines and begin looking for work. Also good for the market!

Not surprisingly, the US market had a strong rally on Friday with all major indices rising, including the NASDAQ 100, which represents so many of the big tech names. Analysts were particularly excited to see tech participation as the sector has lagged throughout most of the year.

But one day rallies do not a trend make, and goldilocks scenarios rarely go beyond the pages of fiction. With May behind us, it looks as though we may see a summer of frustration. Short spurts of upside surprises meshed with choppy intraday action leading to an ever expanding trading range. In that environment, the bear call spread is a clearly defined profit and loss strategy to take advantage of a market subjected to the Goldilocks two step; i.e. one step forward two steps back.

I would also suggest looking at exchange traded funds (ETFs) as the underlying security. By using
ETFs you reduce the impact of company specific risk which is difficult to disseminate and can dramatically alter the metrics.

What Is a Bear Call Spread Strategy?

Suppose that you think the Canadian market as measured by the S&P/TSX 60 Index will fall or even tread water over the next month. That’s the underlying bearish thesis that must accompany any such strategy. If you think the market may decline but not enough to justify an aggressive trade such as shorting the S&P/TSX 60 Index Fund ETF (Symbol: XIU, recent price $17.85) or buying XIU puts, the bear call spread provides an excellent short term alternative.

The bear call spread involves the sale of a call that is either at-the-money or in-the-money combined with the purchase of an out-of-the-money call at a higher strike. It allows you to take bearish stance which, depending upon the strikes you employ, could generate a profit if the underlying security simply remained unchanged until expiry. All the while hedging against an upside surprise perpetrated by another better than expected data point.

Consider the iShares Gold ETF (symbol: XGD, Friday’s close: $12.36) as a case in point. Suppose you are moderately bearish on the outlook for gold and by extension the gold miners that make up XGD. You are not comfortable making a significant bet on a decline in gold by shorting XGD or perhaps buying XGD puts, but you are comfortable that gold is unlikely to rally significantly over the summer months. In that scenario, the bear call spread strikes a reasonable balance.

The strikes that you employ will depend on how aggressive you want to be. Using at at-the-money call hedged with an out-of-the-money call will profit if gold simply remains unchanged over the summer months, although it carries greater risk should gold experience a significant rally.

For example, write the XGD September 13 calls at 65 cents and buy the XGD September 16 calls at 15 cents. This bear call spread generates a credit of 50 cents which is your maximum profit. However, since XGD is already trading below the strike price of the short call even if it remains unchanged until the September expiry the bear call spread will produce its maximum profit.

Risk versus Reward

The advantage with any spread is a clearly defined risk / reward profile. The maximum profit occurs if the underlying security closes below the strike price of the short call, in which case you will retain the premium received. With XGD the maximum profit is 50 cents, which occurs if XGD closes below $13 at the September expiration.

The maximum risk occurs if the underlying security closes above the strike price of the long call, in which case your losses would be limited to the difference in the strike prices less the premium received. The maximum risk with XGD is $2.50, which is the difference in strike prices; $3.00 per share less the net premium received 50 cents.

The breakeven point is calculated as the strike price of the short call plus the premium received. In the case of XGD, the breakeven is $13.50, calculated as the $13 strike price of the short call plus the 50 cents per share premium received.

At expiration there are three possible scenarios;

XGD declines or stays the same in which case both calls would expire worthless and you would retain the net credit which is the maximum profit.

XGD could rise to$13.50, in which case the bear call spread generates neither a profit or a loss.

XGD could rise significantly above the strike price of the long call, in which case you would experience the maximum loss of $2.50 per spread.

In-the-money Bear call spreads

If you wish to take a more aggressive position with pre-defined risk / reward metrics you could sell an in-the-money call and buy an out-of-the-money call. The challenge with this approach is that the underlying security must decline in order for you to earn your maximum return.

On the other hand, you take in a larger credit with this position, which lowers your maximum risk. Again, using the XGD example, you could write the XGD September 12 in-the-money calls at $1.10 and buy the XGD September 15 out-of-the-money calls at 25 cents.

Of course, XGD is but one example. If you were looking for a broader ETF you might consider XIU which holds a representative cross-section of blue chip large cap companies in the Canadian stock market. Another is the iShares S&P 500 Index CDN$ hedged ETF (symbol: XSP, Friday’s close $18.19). This ETF holds the 500 companies that make up the S&P 500 composite index hedged back to the Canadian dollar. In either case, you are taking a slightly bearish position on the broader North American market, which could also deliver additional cash flow throughout the summer months.

You could also use bear call spreads in connection with a long position in the underlying ETF. In this case, you are effectively employing a covered call which will produce excess cash flow, and should the markets rally sharply the long call will hedge against the short call allowing the underlying ETF to generate profits as the summer wears on. This approach may have merit through September, but after that the strategy should be reviewed for its effectiveness as we roll into the fourth quarter.


Bear call spreads are a useful strategy for investors who prefer to use ETFs and are looking for ways to engage in a tightly controlled risk / reward strategy that can profit from a summer slowdown, all the while removing the impact of company specific events.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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