Strategy of Bear Spread

Question

State when markets are anticipated to go down then what is the Strategy of Bear Spread?

Answer 1

This strategy is deployed when the investors have a bearish attitude about the market and expect that the markets would fall in the short term. To pursue this strategy, the trader takes an opposite position i.e. sells a call option with lower exercise price while buys a call option that has the higher strike price. Therefore there is a net premium inflow initially which can be expressed as the difference of the premiums of the 2 call options. Through the use of puts also, the strategy can be structured and accordingly the payoffs as well as profits from this strategy are deduced using put options.

In case that puts are used, initially the strategy would lead to a net outflow of premium as the trader buys the put that has the higher exercise price (K2) and also shorts the put that has a lower strike price (K1). Since puts whose exercise prices are higher are more expensive in contrast to put options that have lower strike prices, there is a net premium outflow at the start which can be represented by -p2 + p1. Accordingly, at expiration, the value of this strategy can be expressed as:

V = max (0, K2 – ST) – max (0, K1 – ST).

The profits that accrue on account of the above strategy are obtained by subtracting from the value of the strategies, the net premium outflow as shown under:

Profit = max (0, K2 – ST) – max (0, K1 – ST) – p2 + p1.

In contrast to the bull spread, profits in this situation result when the prices of the stock (the underlying asset) decline. Profits from the bear spread strategy are maximized only when the short position in the put expires worthless at expiration and there is a net payoff due to the long position in the put option. This strategy has been represented in the graph below:

As can be seen from the diagram, both the profits as well as the losses are limited in this case too, like the bull spread. The only difference is that the payoff occurs only when the stock prices go down and the bearish views of the trader hold good when the options expire. It can be seen here also that the maximum loss occurs when both the options expire worthless and are out of the money and the quantum of the maximum loss is p1 – p2. On the other hand, the maximum gain that occurs can be quantified as:

Maximum profit = K2 – K1 – p2 + p1.

Like the earlier case, it is essential to ensure that the differences in the strike prices of the options exceed the net premium which is paid at the onset to implement the bear strategy. In case of bear spread with calls, the profit occurs only when both the options expire worthless and this is feasible only if the stock price declines during expiration of the option.