Bear Call Spread on Lorillard (LO)

A bear call spread involves selling a call option while purchasing a higher-strike call option with the same expiration month. The short call option is more expensive than the long call option which creates a credit. The objective is to profit from the short options' time decay. Adding a long call option to the short call protects the position from further losses if the underlying rallies past the two strikes. Credit spreads are a safer way to collect premium from a short option as opposed to selling options “naked” (unprotected by another option or underlying stock) which involves unlimited upside risk as with a “naked” call option in this case. If an options trader's outlook on a stock is neutral to bearish, place a bear call spread by selling a call closer to the money and buying a higher-strike out-of-the-money (OTM) call in the same expiration month. This trade is generally done with less then two months left until expiration. The maximum profit for this trade is the net credit that is received. This will be earned if the stock is at or below the short call's strike price at expiration. The maximum loss for the trade is the difference in the long and short call's strike price minus the net credit received. This will occur if the stock is trading at or above the long call's strike price at expiration. Here's an example: Lorillard Inc. (LO) is trading at about $111 at the end of September 2011. The stock has been trading in a range between $98 and $114 since the beginning of June 2011. The stock has never made it to $117 ever. Just above the area, the 120 strike might be a great spot to sell the call for the bear call spread. In this scenario an options trader could sell a 120/125 November bear call spread. Sell the November 120 call for a credit of 2.65 and buy a November 125 call for a debit of 1.45. The total credit on the spread is 1.20. If LO finishes under $120 by November expiration the spread would expire worthless and the options 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 3.80 (5 - 1.20). The breakeven point is $121.20 (120 + 1.20) which is derived from adding the net credit to the short call. To set up a bear call spread effectively requires some knowledge and skill. Traders must learn to trade options from a base level. When trading credit spreads such as the bear call spread, options traders have to analyze what is the maximum profit, the maximum loss and the probability of having a profitable trade.