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Friday September 03, 2010 |
Advanced Strategies for Options -
Vertical Spreads - Bear Put Spread
In
the last section we described a bear spread using calls. A more common variation of the bear spread involves the use
of puts. Once again a
lower strike price is sold and a higher strike price is purchased
but because puts are used these transactions create a debit. This is true because a put with a higher strike price will
sell for more than a put with a lower strike price.
The
put bear spread has the same sort of profit potential as a call
bear spread. There is
both limited profit potential and limited risk. However, put bear spreads have one important advantage over
call bear spreads. When
establishing a put bear spread the investor sells an out-of-the
money put option. This
transaction does not risk early exercise; in fact for the out-of-the money put to be exercised the spread would have to be
profitable. This is
not the case for call bear spreads. In a call spread the investor sells an in-the-money call as
part of the bear spread and thus is at risk of early exercise
before the spread becomes profitable.
A
second advantage of the put bear spread is that puts tend to lose
time value quickly when they go into the money. If the underlying security falls rapidly and both the long
put and short put go into the money the investor may be able to
collapse the spread before the expiration date. This can be a significant advantage because capital
required for the bear spread can then be re-allocated to another
transaction.
Now
that we have some of the formalities out of the way, let’s
examine a case study of a put bear spread.
Once
again Maria believes Cisco Systems (CSCO) common stock is likely to
decline in the near term. She
is reluctant to short sell the stock outright so she chooses to
establish a bear spread. With
CSCO trading at $100 Maria notices that the December 95 puts are
trading at $1.00 and the December 105 puts are trading at $7.00. Maria decides to sell one contract of the December 95 put
and buy and one contract of the December 105 put for a net debit
of $600.
Let’s
examine what happens at expiration
|
Cisco
Systems Share Price at Expiration
|
Profit
for December 95 puts
|
Profit
for December 105 puts
|
Total
Profit
|
|
93
|
($100)
|
$500
|
$400
|
|
95
|
$100
|
$300
|
$400
|
|
97
|
$100
|
$100
|
$200
|
|
99
|
$100
|
($100)
|
$0
|
|
100
|
$100
|
($200)
|
($100)
|
|
103
|
$100
|
($500)
|
($400)
|
|
105
|
$100
|
($700)
|
($600)
|
|
107
|
$100
|
($700)
|
($600)
|
As
you can see Maria gains her maximum profit when CSCO shares fall
to or below $95, the short put strike price. Her maximum loss is her initial debit, this occurs when
CSCO shares rise to or above 105, the long put strike price. Maria’s break-even point occurs when CSCO shares reach
$99, this corresponds to the higher strike price less the initial
debit.
Summary
1. Put bear spreads are preferable over call bear spreads
because the risk of early exercise occurs only when the spread
becomes profitable.
2. The maximum profit is the difference between the long and
short strike prices less the initial debit.
3. The break-even point is the higher strike price less the
initial debit.
bear
call spread 
ratio call spread
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Vertical
Spreads > Bear Put Spread
