Writing covered calls is a popular option-trading strategy that squeezes extra income out of existing stocks you already own.

If the stock doesn’t end up higher than the strike price at expiration of the call option, the option expires worthless. As long as the shares aren’t called away, you can continue sell calls against the stock.

You Need Shares of Underlying Stock

In order to write a covered call, you will need to have shares of the underlying stock. If you merely sold a call without the stock to back it up, that is a naked call.

A naked call is much riskier than a covered call because if the potential loss from the trade is theoretically unlimited.

The lowest a stock can go is zero, but there’s no upper bound to how high a stock can climb. Of course, realistically, a stock isn’t going to go to infinity, but the point is that there could be a huge loss if unhedged.

However, it is possible to sell a call without the underlying stock but still hedge your position to limit the maximum possible loss. You will need to pair the trade with at least one other trade.

One such strategy is the bear call spread.

How It Works

To execute this strategy, in addition to selling a call, you buy another call against the same stock at the same expiration date but at a higher strike price.

The second leg of the strategy ensures that no matter how high the underlying stock goes, you will be able to buy it at the long call strike price to cover your short call.

Let’s use a hypothetical example. Let’s say you don’t like recent EV trends and you think Tesla (NSDQ: TSLA) has more room to fall and you decide to sell an at-the-money (as of this writing) June 180 call against it for $18. But you also realize that TSLA has staged big-time rallies before and you want to protect against that possibility, so you hedge and buy a June 205 call for $9.

These two trades form a bear call spread, and you have a net credit of $900 (($18 – $9) X 100).

Different Scenarios

If TSLA indeed goes down and ends up below $180 at expiration, both calls will expire and your profit is the $900. Note that this $900 is also your maximum potential profit on the spread if you held both legs of the trade to expiration.

As the chart shows, if TSLA ends up between the two strike prices ($180 and $205), then you could gain or lose depending on where in the range the price falls.

Let’s say it ends up at $190, then the short call will be exercised. You have to buy at market and sell at $180. For simplicity’s sake, let’s say you are able to buy at $190, so your loss on the transaction would be $10 per share, or $1,000 total. However, since you have a credit of $900, your net loss would then be $100.

Hedging Against a Big Loss

Even if TSLA exceeds $205 a share, since you can exercise the long call and buy at $205, you limit your loss to a maximum of $1,600. This is because you would exercise the long call and buy at $205 and then sell at $180 for a $2,500 loss, but net of the $900 credit, the net loss is $1,600.

Put another way, if you held both options to maturity, your maximum potential profit would be $900 and maximum potential loss would be $1,600.

I keep saying if you held to maturity because if you close out either or both legs prior to expiration, then your actual gain or loss can fall outside of the range noted above.

Why the Spread Makes Sense

You may be thinking, the potential downside is bigger than the potential upside, why would anyone do this spread?

To execute this spread, you should feel strongly that the stock is going to fall. If the probability of TSLA falling is only 50%, for example, then no the risk/reward of this spread is not worth it. But if you think there’s an 80% of TSLA falling, then the expected value of the trade will be $400—0.8 x $900 + 0.2 x -1,600 = $400. And as mentioned, you can always close out one or both legs of the spread at any time to improve your return.

When done properly, the bear call spread allows you to earn an income without needing to have the cash to buy at least 100 shares of the underlying stock for a covered call.

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