An investor who enters into a bear spread has mild to moderate bearish perspective, that is, he is hoping that the prices will decline. A spread that is designed to profit if the price goes down is called a bear spread. Bearish vertical spreads are created by buying high strike option and selling low strike option.
Bearish vertical spreads with calls are created by the sale of a call with a low strike (exercise) price and purchase of call with a high strike (exercise) price. It produces a net credit strategy since a low strike price option is more expensive than high strike price option. The maximum profit is equal to net premium received and the maximum loss is equal to higher strike option price less lower strike option price less net premium received. The break even price is equal to lower strike price plus net premium received. Thus, the bear spread with call options not only limits the trader’s risk but it also limits the profit potential, that is, it limits both the upside potential as well as the downside risk.
Suppose an investor buys one market lot of February 1,500 Nifty calls at Rs 60 a call and sells one profits gets reduced to the extent it falls short of the lower strike. In this case, the index falls short of the lower strike by 20. Hence, his pay-off is Rs 96 – 60 – 20 = Rs 16.
In case of bearish option spreads with puts, the investor buys a put with a high strike price and sells a put with a low strike price. This produces a net debit strategy as high strike price option is more expensive than low strike price option. The maximum profit is equal to higher strike price option less lower strike price option less net premium paid. The maximum loss is equal to net premium paid. The break even price is equal to higher strike price les net premium paid. Thus, the upside potential and downside risk is limited.
A vertical spread is used by an investor when he believes that the prices will move only to the strike price that generates maximum profit.
Horizontal spreads: calendar spreads: A horizontal, or calendar spread is a spread where the options used have the same strike price but different expiration dates. A calendar spread trading strategy is used by an investor who thinks that the market will be weak in the short term but rally in the long tem. The investor makes an attempt to gain from the declining time value of options. Calendar spread can be created with call options as well as put options.
A calendar spread can be created by selling a short maturity call option with a certain strike price and buying a longer maturity call option with the same strike price. The two option series would be identical in every respect except the expiry month. The short option position is a liability while a long option position is an asset. The value of the liability declines more quickly than the value of the asset. Hence, the option should be allowed to run to the expiry date. As the longer maturity option is expensive, a calendar spread requires an initial investment. The investor makes a profit if the stock price at the expiration of the short maturity option is close to the strike price of the short maturity option, otherwise a loss is incurred. The downside risk is limited to the initial debit incurred for establishing the spread. The break even point at expiry is the strike price plus premium. There is a risk of the sold option being called that is, exercise. A calendar spread can be created with call options as well as put options.
In calendar spread with put options, the investor buys a long maturity put option and sells a short maturity put option. In a bullish calendar spread, a strike price higher than the current stock price is chosen while bearish calendar spread involves a lower strike price. In a reverse calendar spread, the investor buys a short maturity option, and sells a long maturity option.