An In-Depth Look At Vertical Option Spreads, Part II By Tony Saliba

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 bullish; and conversely, if he buys the higher exercise price and sells the lower one 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 @ $5 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. Above 95 both options have intrinsic value, and as we have seen in previous lessons, 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.

b) Maximum loss: 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 Cost $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

b) 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 1 ITI JAN $70 put @ - 2

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

$80 - $3 = $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.