Bear Vertical Spread Explained
Published on February 24, 2016
Published on February 24, 2016
What is a Vertical Spread? We explained this at great length in the previous article using an example of Bullish Vertical Spread. We explained all the basics of vertical spread, how to structure it, how to analyze its risk reward profile and how to interpret profit & loss of a bullish vertical spread. This article is now focused to explain what is Bear Vertical Spread.
Before analyzing bearish trading strategy using verticals, let’s review what is a Vertical Spreads strategy:
Bear vertical spread is an options trading strategy designed to profit from a decline in prices. It is constructed by purchasing a certain number of options and simultaneously selling an equal number of options. Both sold and purchased options have to be the same class (i.e. Call or Put), same underlying security, same expiration date, but at different strike prices.
It can be structured (set up) in two ways:
When constructed with similar strike prices and similar expiration dates, both Bear Put Spread and Bear Call Spread have almost the same risk/reward profile, as we will show in our chart/graph example. A Trader may choose either of the two vertical spreads for trading his directional view. However, it is much better to structure a trade based on:
Generally speaking, it is better to structure a trade using “out of the money” options as it will be easier to fill.
Using a hypothetical example of a stock, which is trading at $50 at the moment, we will now review Bear Put Spread and possible outcomes (profit/loss). Let’s assume-
Here is the price chart marked with entries for structureing bear spread using Put Option:
Since it costs us to open this spread, it is called a Debit Spread. In this case, our Initial Debit is $0.30 per spread. ($30/100 = $0.30).
Let’s take a look at the same chart with profit/loss areas when price moves in different directions as the expiration date draws near.
The price at $47.70 represents our breakeven point, and any price move below that value would result in profit.
Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:
As you can see, the price can be at any value above $48.00 – it will not affect our loss which is capped at $30 – which is the actual amount of our Debit. Moreover, the price of this stock may even go to $0 – it will not affect our maximum profit which is capped at $170.
Here are the detailed calculations of our Bear Put Spread, with regard to different stock price scenarios at the expiration date (Jan 31st).
Scenario 1: Stock is equal to or below $46.00, let’s say at $44.00
In this case we would make maximum gain. Profit would be calculated based on intrinsic values of Put Options at expiration.
Profit/loss = Ip – Is – Initial Debit = $4.00 – $2.00 – $0.30 = $1.70. Since options come in lots which represent 100 shares, our profit will be $170.00 ($1.70 x 100 = $170.00). Compared to our initial investment (Debit) it is a 566% gain ($170/$30 = 566%).
Scenario 2: Stock is equal to or above $48.00, let’s say at $52.00
In this case we would make maximum loss. Let’s show the exact calculation based on intrinsic values of Put Options at expiration.
Profit/loss = Ip – Is – Initial Debit = $0 – $0 – $0.30 = -$30.00 ($0.30 x 100). Our maximum loss in this case is $30 – which is the amount we “spent” for purchasing this Bear Put Spread.
Scenario 3: Stock price is somewhere in between our Put Options, let’s say at $47.00
We will calculate our profit/loss based on intrinsic values of our Put Options at expiration.
Profit/loss = Ip – Is – Initial Debit = $1.00 – $0.00 – $0.30 = $0.70. Since each option controls 100 shares, our gains would be $70.00 ($0.70 x 100). That is 233% gains ($70/$30 = 233%).
Try now. Use any of the free finance portal e.g. Yahoo Finance, choose an underlying e.g. Apple (Symbol: AAPL), find option prices and construct a Bear Put Spread. Let me know (via comments below) what you did and I will be happy to share my thoughts if you got it right.
Now, let us set-up the same trade using Call Options. We shall use same set of assumptions i.e. based on same hypothetical stock example we used when we constructed Bear Vertical Spread with Put Options i.e. stock is trading at $50.00 at the moment, and expiration date is Jan 31st.
First we will buy 1 Call Option with a strike price of $48.00. Simultaneously, we will sell 1 Call Option with a strike price of $46.00. Let’s assume the credit we received with these combined options is $1.70. Since each option controls 100 shares, we would receive $170 credit.
The goal of this strategy is to benefit from the decline in the stock prices to potentially below $46.00 enabling us to keep the $170 credit premium.
Here is the chart with Bear Call Spread Set-up:
Let’s show the profit/loss graph which is practically same as with Bear Put Spread, the only difference being in the purchase/sale of the respective calls.
It is because we are comparing the risk/reward profile with respect to Bear Put Spread and we are using the same strikes. And since we are constructing this trade using Call Options, it will be opposite of Bear Put Spread.
By setting up two options in this manner, we have constructed (or sold) a Bear Call Spread and we collected $170 credit. Since it gave us credit to open this spread, it is called a Credit Spread. In this case our Initial Credit (Ic) is $1.70 (or $1.70 x 100 = $170).
Detailed calculations of risk/reward are explained below:
Scenario 1: Stock is equal to or below $46.00, let’s say at $42.00
In this case we would make maximum profit which can be calculated with intrinsic values of both calls at expiration date.
Profit/loss = Initial Credit + Ip – Is = $1.70 + $0 – $0 = $1.70. Since each option controls 100 shares our profit would be $170 ($1.70 x 100). In this case we would get to keep all the credit we collected by opening this kind of spread. We would achieve maximum reward of 566% ($170/$30).
Scenario 2: Stock is equal to or above $50.00, let’s say at $52.00.
In this case would make maximum loss which can be calculated with intrinsic values of our options at the expiration date.
Profit/loss = Initial Credit + Ip – Is = $1.70 + $4.00 – $6.00 = -$0.30. Our loss would be $0.30 per share, and since each option controls 100 shares, our maximum loss would be $30.
Scenario 3: Stock is in between our strike prices, let’s say at $47.00
In this case we would make partial profit – which will again be calculated based on intrinsic values of options at expiration date.
Profit/loss = Initial Credit + Ip – Is = $1.70 + $0 – $1.00 = $0.70. Since each option controls 100 shares, our profit would be $70. Reward in this case is 233% ($70/$30).
As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bear Put Spread or Bear Call Spread using the same strikes. However, as mentioned earlier, it is much better to structure a trade based on bid/ask slippage and ease of fill which, generally speaking, is good for out of the money options.
Bottom line, it will be much better to use Bear Put Spread vs. Bear Call Spread (in this example) as Puts will be much easier to be filled vs. Calls which are deep in the money.
In this post I covered BEARISH VERTICAL SPREADS using both put options and call options. In the earlier post, I covered BULLISH VERTICAL SPREAD in a very comprehensive manner. The nature of this strategy is LIMITED RISK, LIMITED PROFIT. Use this spread to trade directionally to minimise your risk.
Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.
How do you like it? What additional thoughts or questions do you have? I will answer every question, no strings attached. Make sure to leave your comments or questions so you can make the most of your learning.