Deep ITM Bear Call Spread

Deep ITM Bear Call Spread Risk Graph
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Deep ITM Bear Call Spread - Introduction



The Deep In The Money Bear Call Spread is a complex bearish options strategy with limited profit and limited loss. What makes it so interesting is that even though it takes a significant drop in price of the underlying stock to become profitable with this options trading strategy, it does have one of the best reward risk ratio for bearish options strategies. In fact, it could even become an arbitrage position!

This free options strategy tutorial shall explore the Deep ITM Bear Call Spread in depth, explain how to use it, how to turn it into an arbitrage, its calculations and more.
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Deep ITM Bear Call Spread - Classification



Strategy : Bearish | Outlook : Sustained Bearish | Spread : Vertical Spread | Debit or Credit : Credit


What Is Deep ITM Bear Call Spread


Deep ITM Bear Call Spread is simply a Bear Call Spread using deep in the money strike prices. A regular Bear Call Spread writes at the money call options and then buy out of the money call options in order to partially offset margin requirements and to put a ceiling to the maximum loss possible by the position. This resulted in an options trading position which profits when the price of the underlying stock goes sideways or downwards with greater maximum loss potential than maximum profit potential, a negative reward risk ratio. However, when strike prices are moved in the money, the reward risk ratio of the position starts to come around and will come to a point when it becomes positive. Like a regular bear call spread, a deep in the money bear call spread requires the price of the underlying stock to close below the short strike in order to return its maximum profit potential, which in this case would mean dropping significantly. However, this results in a reward risk ratio as high as 9:1 due to the extremely small maximum loss of the deep ITM bear call spread.

The Deep ITM Bear Call Spread has such an amazing reward risk ratio due to the extremely small maximum loss potential. This is a result of the long call leg being in the money and would rise almost dollar for dollar with the short call leg if the price of the underlying stock goes upwards instead. The long call leg in a regular bear call spread is out of the money and would require the price of the underlying stock to rise significantly in order to take it in the money before it is able to completely hedge against the loss on the short leg.


When To Use Deep ITM Bear Call Spread?


The Deep ITM Bear Call Spread could be used when one expects the price of the underlying stock to move down significantly by options expiration, wants as low a maximum loss potential as possible and has an options trading account level high enough for credit spreads.



How To Use Deep ITM Bear Call Spread?


Deep ITM Bear Call Spread consists of writing a deep in the money call option with the buying of the same amount of call options of the same expiration month at a higher in the money strike price.

Buy ITM Call + Sell Deep ITM Call



Deep ITM Bear Call Spread Example


Assuming QQQ is trading at $63 and its May $60 strike price call options are trading at $3.06 and $55 strike price call options are trading at $7.94.

Buy To Open 1 contract of May $60 Call at $3.06
Sell To Open 1 contract of May $55 Call at $7.94

Net Credit = $7.94 - $3.06 = $4.88





Choosing Strike Price and Expiration Month for Deep ITM Bear Call Spread


The choice of expiration month depends on how long you think it will take the price of the underlying stock to go below the strike price of the short call options. If you expect an extremely quick move downwards, then using the nearest expiration month is ok but if you expect the move downwards to be completed in 3 months, then using options with at least 3 months to expiration would be in order. As Deep ITM Bear Call Spreads typically have a very far breakeven point, sufficient time should be given for such a move to happen.

The choice of strike price for the short call options depends on how low you think the price of the underlying stock would go down to and beyond. In the example above, we are expecting QQQ to drop down to and beyond $55, hence writing the $55 strike price call options. Bear in mind that the lower the strike price of the short call leg, the higher the maximum profit potential would be but the more the price of the underlying stock needs to drop in order to achieve maximum profit and breakeven.


Deep ITM Bear Call Spread Arbitrage


Deep ITM Bear Call Spread can become an arbitrage position with no possibility of loss. In this case, instead of making a loss when the price of the underlying stock remain stagnant or rises, it will make a very small profit and make a big profit if the price falls strongly, resulting in the risk graph below.

Deep ITM Bear Call Arbitrage Risk Graph

This happens when the net credit of the position exceeds the difference between the strike prices. This could happen naturally or it could happen by legging into the position successfully.

Deep ITM Bear Call Spread Arbitrage Example 1


Assuming QQQ is trading at $63 and its May $60 strike price call options are trading at $3.06 and $55 strike price call options are trading at $8.10.

Buy To Open 1 contract of May $60 Call at $3.06
Sell To Open 1 contract of May $55 Call at $8.10

Net Credit = $8.10 - $3.06 = $5.04

Minimum profit = $5.04 - (60 - 55) = $0.04 with no possibility of loss.

Deep ITM Bear Call Spread Arbitrage Example 2 - Legging


Assuming QQQ is trading at $63 and its May $60 strike price call options are trading at $3.06 and $55 strike price call options are trading at $7.94. You decided to leg into the position and managed to fill at the following prices:

Buy To Open 1 contract of May $60 Call at $3.06
Sell To Open 1 contract of May $55 Call at $8.10

Net Credit = $8.10 - $3.06 = $5.04

Minimum profit = $5.04 - (60 - 55) = $0.04 with no possibility of loss.
In both cases above, the Deep ITM Bear Call Spread would make a minimum profit of $0.04 with no possibility of loss, making it an arbitrage position.



Trading Level Required For Deep ITM Bear Call Spread


A Level 4 options trading account that allows the execution of credit spreads is needed for the Deep ITM Bear Call Spread. Read more about Options Account Trading Levels.



Profit Potential of Deep ITM Bear Call Spread


Deep ITM Bear Call Spreads achieve their maximum profit potential when the underlying stock closes at or below the short strike price by expiration. The profitability of a Deep ITM Bear Call Spread can also be enhanced or better guaranteed by legging into the position properly.



Profit Calculation of Deep ITM Bear Call Spread


Maximum Profit = Net Credit
Maximum Loss = Difference Between Strikes - Net Credit

Deep ITM Bear Call Spread Profit/Loss Calculation


Assuming QQQ is trading at $63 and its May $60 strike price call options are trading at $3.06 and $55 strike price call options are trading at $7.94.

Buy To Open 1 contract of May $60 Call at $3.06
Sell To Open 1 contract of May $55 Call at $7.94

Net Credit = $7.94 - $3.06 = $4.88

Maximum Profit = $4.88

Maximum Loss = (60 - 55) - $4.88 = 5 - 4.88 = $0.12

Reward Risk Ratio = $4.88 / $0.12 = 40.6

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Risk / Reward of Deep ITM Bear Call Spread



Upside Maximum Profit: Limited

Maximum Loss: Limited



Break Even Points of Deep ITM Bear Call Spread:


A Deep ITM Bear Call Spread is profitable if the price of the underlying stock falls below the breakeven point.

Breakeven = Higher Strike - Maximum Loss Potential

From the above Deep ITM Bear Call Spread example :

Maximum Loss = $0.12, Higher Strike = $60

Breakeven = $60 - $0.12 = $59.88

This Deep ITM Bear Call Spread would start to become profitable when the price of QQQ falls from $63 to $59.88 and beyond. This means a drop of 4.95% in the price of QQQ in order to reach breakeven, which is a very significant downwards move. This far breakeven point is one of the most significant disadvantage of the Deep ITM Bear Call Spread and why it should be used only when a significant downwards move is expected.



Deep ITM Bear Call Spread Greeks



Delta: Negative
Deep ITM Bear Call Spreads have negative delta which allows it to profit as the price of the underlying stock goes down. This is characteristic of all bearish options strategies.

Gamma: Positive
Being slightly Gamma Positive, the delta of a Deep ITM Bear Call Spread will becoming increasingly negative as the price of the underlying stock goes down, increasing its profitability downwards.

Vega: Positive
Vega for Deep ITM Bear Call Spreads tends to be positive and will increase the value of the position when implied volatility goes up and decrease value when implied volatility goes down.

Theta: Slightly Negative
Deep ITM Bear Call Spreads are not significantly affected by Time Decay as the erosion of extrinsic value on the long legs are offset by the erosion of extrinsic value on the short leg. However, the long leg tends to decay slightly faster than the short leg.



Advantages Of Deep ITM Bear Call Spread



:: Highest ROI of the complex bearish options trading strategies.

:: Able to achieve arbitrage when legged in correctly.



Disadvantages Of Deep ITM Bear Call Spread:



:: Requires margin.

:: Requires a big downwards move in order to become profitable.



Adjustments for Deep ITM Bear Call Spreads Before Expiration :



1. When the price of the underlying stock has fallen below the strike price of the short leg and is expected to stage a pullup, one could Buy To Close the short leg and hold the long leg, transforming the position into a Long Call in order to profit from such a pullup.

2. When the direction of the breakout has become uncertain and that the price of the underlying stock has an equal chance of a significant topside breakout, one could add a Deep ITM Bull Put Spread to the position, transforming it into an ITM Iron Condor Spread to profit from a breakout in either direction. One could also close out the short leg and then buy another ITM Put option to transform the position into a Long Gut spread which also profits from a breakout in either direction. Such transformations can be automatically performed without monitoring using a Contingent Order.

3. The deeper in the money the short options are and the nearer to expiration it gets, the higher the chance of them getting assigned early. If that happens, the short call options will be replaced with short stocks and transform the position from a Deep ITM bear call spread into a Synthetic Long Put with unlimited profitability to downside. If you think the stock is going to continue going downwards, you can continue to hold this new position. If you are of the opinion that the stock is going to reverse into a rally, you can close out the short stock position and just hold on to the long calls.


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