An In-Depth Look At Vertical Option Spreads, Part II
III.
The Bear Call Spread
In
the last lesson, we investigated the nature and nuances of Bull Spreads. We also
talked a bit about debit and credit spreads, and even calculated some important
values when initiating spreads, such as the maximum gain, maximum loss and the
breakeven. This lesson will finish up our trot through vertical spreading
strategies by concentrating on Bear Spreads.
The
Bear Spread is a hedged strategy that
can be composed with either puts or calls. Like the Bull Spread, the Bear Spread
offers the trader a compromise: limited reward for limited risk.
The trader or investor putting on a Bear Spread has an opinion on the
direction of the underlying; he expects the underlying to decline.
Various reasons for putting on
the Bear Spread exist: the investor
might want to enter into a position immediately to take advantage of this
decline, but has decided that the cost of entry of a naked long put position is
too high or the investor/trader might have a specific price target on the
underlying.
Recall we said
that by definition, if the trader/investor buys the option with
the lower exercise price and sells the option with the higher exercise price the
spread is bearish.
It follows then,
that if we are putting on a Bearish Spread,
and one with calls, it would look
something like this:
Buy 1 ITI June 95
Call
@ $3 debit
Sell
1 ITI June
90 Call
credit
$2 credit
Note that if ITI
is below 90 at expiration, both options expire worthless.
Why? Because these are calls, and
calls have intrinsic value only when the underlying is trading above the
option’s strike price. The two strike
prices are 90 and 95, so anything under 90 means no intrinsic values for the
calls.
But is this a good
or a bad thing for us here? It is a good thing for us!
This is a bear spread, so if we put it on we want
the market to go down. Remember, we
already put on the spread and collected $2 for it. So if both options expire
worthless, then we simply pocket the $2 credit. (See the last lesson for a
refresher on Credit and Debit Spreads or e-mail me at tonys@tradingmarkets.com
key word Credit in the subject line).
If ITI expires
above 95, then the spread would be worth its maximum of $5.
Why? Again, since you understand how calls work, this is common sense.the maximum a spread can
be worth is the difference between the strike prices of its legs. Now do the
math: Here 95-90 = 5
But be careful!
We don’t collect $5 here. Remember
we already
received a $2 credit. We are SHORT the spread. So in this we received a credit
of $2 for a spread that ended up being worth $5. We just lost $3 on the deal.
(Poor, but possibly better than being short the stock or naked calls.)
To summarize:
a) Maximum Profit:
For the Bear Call Spread, this is the credit received, in this case
$2.
For the Bear Call Spread, the maximum loss is equal to the maximum possible value of the spread minus the credit received.
In the above case,
($95-$90)- ($2)
=
$5
– $2 = $3
c)
The breakeven is the short strike plus the amount received for the
spread.
$90 + $ 2 = $ 92
Hint:
The call we are short will lose money for us with the stock rising. It will lose
to the extent until the upper strike will stop the losses and “kick in†for
us, thus the max of $5 in this case. Since we collected $2 to begin with, the
worst we can do is lose $3 and the point where we start losing (the Breakeven)
is that lower strike plus the amount we took in…$92.
IV.
The Bear Put Spread
This
section concludes our brief overview of the various varieties of the Vertical
Spread. The Bear Put Spread is composed of both a long put and a short put where
the long put has the higher strike and the short put has the lower strike price.
For example:
Buy 1 ITI
JAN. $80 put
@ $5
paid
Sell
1 ITI JAN
$70 put @
– $2 received
$3
(debit)
The
cost of the spread is the difference between the premium paid for the long
option, and the credit received from the short option.
Let’s
try to figure out what the maximum risk and reward is for our hypothetical ITI
spread. Worst-case scenario, say ITI closes above $80 at expiration, and
therefore, both legs expire out-of-the-money. Well,
then both options expire worthless, and the trader/investor loses the $3 he paid
for the spread. Thus:
a)
Max Loss: The Bear Put Spread is a
debit spread, The maximum amount of loss in a debit spread (one that has been purchased) is the amount paid for it. In this case
$3.
$5 debit
$2
credit
$3 debit
Max Profit: Figuring
out the Profit (reward) is a bit more complicated, but should still present us
with little difficulty. Note that in our
hypothetical ITI spread above, the short ITI $70 put has value if ITI is
trading below $70. Below $70, the
value of the short put would match, dollar for dollar, the value received for
the in-the-money $80 put. The maximum
profit for a Bear Put Spread is limited to the difference in strike prices
(strike2 – strike1) MINUS the difference in the premiums (option2 – option1)
when the underlying is below strike 1 at expiration.
(Assuming
underlying below 70)
Long
1 ITI JAN.
$80 put @
5
Short JAN
$70 put @
– The
two strikes: (80-70) less the money spent/received – (5 – 2)
($10)
– ($3)
= $7
The
most we can make on this spread is $7.
Finally, the Breakeven:
c)
Breakeven: Higher
Strike price minus net premium paid
73
It
is important to note that the “Bearishness†of the Put Spread is determined
by the strike price of the short put.
Again, this makes
intuitive sense. The farther away, or
“out-of-the-money†the short put is, the farther the underlying has to drop
for the spread to reach its maximum value
V.
Vertical Spreads: Some Loose Ends
In
this final section, I’ll summarize some essential points to memorize in order
to become a more proficient directional spreader:
1.
Staying
Spread is Staying Alive: Putting
on a spread means trading the possibility of unlimited reward for the benefit of limited risk.
2.
Vertical Spreads are combinations that are put on by the trader who has
an opinion on the direction of the underlying. A
Bear Spreader believes the underlying is going down, while a bull spreader feels
it is going up.
3.
A Vertical Spread consists of at least one long option and one short
option where both options are of the same type (puts or calls) and expiration,
but have different strike prices. One-to-one verticals are typical, have limited
risk/reward profiles and are all we have discussed. But ratioed vertical spreads
are also strategies that are popular amongst advanced options traders and
carried very different risk characteristics.
4.
A spread’s maximum value is defined as the difference of the strike
prices of the two legs that compose it.
5.
The maximum amount of profit in a debit spread (one that has been
purchased) is the maximum value of the spread minus the net amount paid.
6.
The maximum loss of a debit spread is the amount paid for it.
7.
The maximum profit potential of a credit spread (one that is sold) is the
amount of cash received.
8.
The maximum loss possible in a credit spread is the maximum value of the
spread minus the amount received from selling it.
9.
At expiration, the vertical spread will be worth zero if both options are
out-of-the-money.
10.
Be patient and don’t overtrade.