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:

• Vertical spread is an option spread trading strategy in which trader purchases a certain number of options and simultaneously sells 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.
• Since purchased and sold options are of the same class (either puts or calls), a trader’s positions are hedged against each other – while one option is making money the other option is losing money.
• By setting up (structuring) options in this manner, trader limits the risk involved, but at the same time trader limits the profit potential too.

Vertical Spreads can be either Debit Spread or Credit Spread, and can be created with either all Call Options or all Put Options and can be created for Bullish or Bearish directional view.

What is a Bear Vertical Spread?

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:

• By using Put Options – “Bear Put Spread” – also called a Put Debit Spread.
• By using call options – “Bear Call Spread” – also called a Call Credit Spread.

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:

• Bid/Ask slippage
• Ease of fill

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-

• We are bearish on this stock, for whatever technical or fundamental reason, and we assume it will decline in price moderately by the end of this month.
• Let’s suppose our bearish signal occurred today (Jan 18^th for example) and Bear Put Spread is the strategy of our choice. Important note is the expiration date of our Put Options, which is Jan 31^st.
• On Jan 18^th we decided to go with our strategy, having in mind the expiration date is Jan 31^st.
• Stock is currently trading at $50.00 per share.

How to Set-up Bear Vertical Spread Using Put Options?

Here is the price chart marked with entries for structureing bear spread using Put Option:

How to Structure A Bear Put Spread?

• As shown in the chart, first we will buy 1 Put Option with a strike price at $48.00, which is trading at $0.40 per share (for example) – since 1 options controls 100 shares, we will spend $40 for this put ($0.40 x 100 = $40).
• At the same time, we will sell 1 Put Option with a lower strike price of $46.00, which is trading for $0.10 per share – for this sale we would receive $10 ($0.10 x 100 = $10).
• By setting up two options in this manner, we have constructed (purchased) a Bear Put Spread which costs us $30. We spent $40 for buying the $48.00 strike put, while we received $10 for selling the $46.00 strike put ($40 – $10 = $30).

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.

• Our options (long put and short put) are hedged against each other – the $48.00 strike long put starts to make money as soon as price falls below the $48.00 value. At that time our short put is still “out of the money”, but as soon as price falls below $46.00 value, that short put starts working against us (remember, we sold that put to somebody). Since these options are the same class and in same number, and price may fall significantly lower than $46.00 – it won’t have any effect on our profit. Thus maximum profit will be realised when stock price drops below $46.00.
• Price at $47.70 is our breakeven point, and price movement below that point will lead us to profit (“partial profit”), as shown in the chart. It will do so until $46.00 strike price is reached, which represents our maximum profit price.
• In case price stays above $48.00 value, we will lose only the initial amount we spent for this investment (Bear Put Spread Debit) – $30.

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.

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Geek’s Notes: Detailed calculations of the Risk/reward

Here are the detailed calculations of our Bear Put Spread, with regard to different stock price scenarios at the expiration date (Jan 31^st).

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.

• Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $44.00 = $4.00.
• Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $44.00 = $2.00.

Profit/loss = I_p – I_s – 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.

• Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $52.00 = $0.00 (since it can’t have negative value).
• Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $52.00 = $0.00 (since it can’t have negative value).

Profit/loss = I_p – I_s – 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.

• Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $47.00 = $1.00.
• Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $47.00 = $0.00 (since it can’t have negative value).

Profit/loss = I_p – I_s – 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%).

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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.

How to Set-up Bear Vertical Spread using Call Options?

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 31^st.

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:

• Our both sold and purchased call options are “in the money” since at the moment of setting up this trade, the stock price is above them.
• The $48.00 strike price Call Option starts working against us as soon as stock price declines to or below the $48.00 strike price. But as stock price declines, the Call Option we sold (strike price $46.00) is working for us the whole time – options are hedged against each other.
• If price declines below $46.00, both options would expire worthless, and we would get to keep the premium we received as our maximum profit, which is $170 ($1.70 x 100 shares).

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.

 

Why buy higher strike and sell lower strike in case of Bear Call Spread?

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 (I_c) is $1.70 (or $1.70 x 100 = $170).

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Geek’s Notes: Detailed calculations of the Risk/reward

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.

• Intrinsic value of purchased Call Option (strike price at $48.00), I_p = $42.00 – $48.00 = $0 (since it can’t have negative value).
• Intrinsic value of sold Call Option (strike price at $46.00), I_s = $42.00 – $46.00 = 0$ (since it can’t have negative value).

Profit/loss = Initial Credit + I_p – I_s = $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.

• Intrinsic value of purchased Call Option(strike price at $48.00), I_p = $52.00 – $48.00 = $4.00.
• Intrinsic value of sold Call Option (strike price at $46.00), I_s = $52.00 – $46.00 = $6.00.

Profit/loss = Initial Credit + I_p – I_s = $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.

• Intrinsic value of purchased Call Option (strike price at $48.00), I_p = $47.00 – $48.00 = $0 (since it can’t have negative value).
• Intrinsic value of sold Call Option (strike price at $46.00), I_s = $47.00 – $46.00 = $1.00

Profit/loss = Initial Credit + I_p – I_s = $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).

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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.

Be Patient with Yourself

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.