--%>

Strategy of Bear Spread

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

E

Expert

Verified

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:

1902_bear spread.jpg

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. 

   Related Questions in Corporate Finance

  • Q : What is Project Budget Project Budget :

    Project Budget: Collecting all costs related with completing a project is budget process. The Project Management Institute states that "aggregating the predictable costs of individual actions or work projects (establishing) an authorized cost baseline

  • Q : Porters Primary activities Porter’s

    Porter’s Primary activities: 1. Inbound Logistics: • Suppliers’ details.• Storage details with respect to materials.• Details regarding pl

  • Q : What are capital investment The capital

    The capital investment appraisal techniques such as NPV, IRR, ARR, PV and Time value of money have become irrelevant post Celtic Tiger. Due to the depth of the recession companies do not have budgets to invest. Discus First use this information when you are writing this essay: 1.&

  • Q : Explain the structure

    Our company (A) is going to buy the other company (B). We need to value the shares of B and, thus, we will use three options of the structure Debt/Shareholders’ Equity in order to obtain the WACC as: 1) Present structure of A

  • Q : Additive risk in the CAPM Suppose that

    Suppose that the two securities APPL and MSFT account for the entire large cap technology component of the S&P 500 (hypothetically – of course – there are really plenty of others). Further, suppose that their weights in the S&P index were as follow

  • Q : Finc . A&B Enterprises is trying to

    . A&B Enterprises is trying to select the best investment from among four alternatives. Each alternative involves an initial outlay of $100,000. Their cash flows follow: Year A B C D 1 $10,000 $50,000 $25,000 $ 0 2 20,000 40,000 25,000 0 3 30,000 30,000 25,000 45,0

  • Q : Yield to maturity problem Jenny is

    Jenny is looking to invest in some 5-year bonds which pay annual coupons of 6.25 % and are presently selling at $912.34. What is the present market yield on these bonds? (Round to the closest Answer.) (1) 9.5%  (2) 8.5%  (3) 6.5%  (4) 7.5%

  • Q : Explain the way of estimating an average

    Explain the way of estimating an average.

  • Q : Explain Straddle and Strangle Straddle

    Straddle & Strangle: In the case of shorting butterfly spread, it can be seen that the gains are limited. However, there exists another strategy known as straddle which produces unlimited gains. This strategy benefits when the trader expects that

  • Q : Problem on maintaining dividend Jackson

    Jackson Company has 6 million shares of common stock selling at $55 each. It also has $120 million in long-term bonds with coupon 7%, selling at 90. The tax rate of Jackson is 33%. Next year its EBIT is expected to be $25 million with a standard deviation of $7 millio