In previous sections, we laid out the basics of using an option spread strategy to take advantage of certain market conditions and how to use to to establish a bullish position. These combinations of option positions allow an investor to take advantage of predicted moves in the stock, while at the same time limiting risk.
Here, we'll outline some of the more common spread strategies that use a spread to take advantage of a bearish outlook for a particular asset. In these cases, the investor is looking for a decline in the stock, but sets up the spread in order to hedge against the possibility that the stock will rise.
The Bear Call Spread, or Short Call Spread, is a vertical spread, meaning that the options involved carry the same expiration, but the strike prices are different. To set up the spread, an investor would sell call options for a certain strike price. Meanwhile, he or she will simultaneously buy the same number of calls at a higher strike price.
The profit is realized from the premium obtained by selling the calls. The purchased calls are a hedge in case the stock unexpectedly rallies. If the stock makes its predicted decline (remember: this is a bearish position, so it is put in place when the investor is predicting the stock will fall), the purchased calls will expire out of the money.
In a Bear Put Spread, or Long Put Spread, puts are purchased for one strike price, while the same number of puts are sold for a lower strike price. This is a vertical spread, so the expiration dates for the puts are the same. The structure of the Bear Put Spread is the opposite as the Bear Call Spread. As noted above, in the call strategy, cash is brought in when the trades are set up. Setting up the put strategy requires a net cash outlay. There is an outflow initially and profits are (hopefully) realized later, when the price of the underlying stock makes its predicted decline.
The advantage of setting up the Bear Put Spread compared to a simple, vanilla bearish bet is that the sale of the put for the lower strike price acts to mitigate the cost.
The downside is that the investor limits his or her profits. The strategy creates a ceiling for the potential upside.
The potential profit or loss are the same for the both the Bear Put Spread and the Bear Call Spread, taking the net cost of carry into account. Both strategies have limited profit potential, along with a limited risk profile.
However, the Bear Call Spread realizes cash upfront, with any potential losses to be paid out later. The Bear Put Spread requires a cash outlay at the start, with possible profits coming down the road. Choosing between them would depend on the individual investor’s cash position and how they are looking to manage their cash flow while taking a bearish position on a particular underlying asset.
Take a look at the following example of a Bearish Call Spread and Bearish Put Spread taken from SPY [SPY Strategy Payout]. The current stock price is 210.00. For the bear call spread, the trader in this case sells the 210 strike for $3.50 and buys the 215 strike for $1.10. For the bear put spread, the trader buys the 210 strike for $3.30 and sells the 205 strike for $1.75, pocketing the $1.55 difference in premium in the short term.