A bear spread is a combination of call options designed to profit from a rise in the price of the underlying security. The "bear" means that we are looking to profit from a decline in prices, whereas the spread is showing that we are spreading our risk among various option positions.

When an investor enters into a bear spread they will purchase one call option whose strike price is above that of the underlying, while simultaneously selling an option with a strike price lower than that of the underlying. In other words, if a stock is trading at $100, then the option strategist could sell a XYZ November 95 call, while simultaneously buying an XYZ November 105 call. Here the option investor wants to profit from a fall in the stock price, but also hedge to prevent any sort of nasty draw down due to the stock taking off. This is accomplished by buying the out of the money call option for protection against a rise in prices, while selling the in the money option to capitalize on the anticipated downturn in the share price.

For example, let's say you are bearish on company XYZ because they have an announcement forthcoming on earnings and you think they will disappoint. You, therefore, would like to profit from the anticipated decline in the stock's price, but want to be protected in the case of an upside earnings surprise.

The stock is currently trading at 100. The front-month strike of 105 from the call side is trading at $3, while the 95-strike is trading at $7. To enter the bear spread you buy the call priced at three, while selling the call priced at seven. Since you are selling the higher priced asset and buying the lower priced, your transaction gives you a credit balance of $4 (-3+7=4). The net gain of the transaction then becomes $4.

If the stock moves down to 95 then the bear spread earns $4. This is the difference between the dollars paid ($3) versus the dollars received ($7). The spread breaks even when the stock trades at 99, while a maximum loss of $6 is experienced when the stock moves to 105, or higher. Therefore, the profit and losses are contained in a bear spread. The obvious disadvantage, however, is that the profit potential falls short of the loss potential.

Price Headley is the founder and chief analyst of BigTrends.com.