--%>

Strategy of Bear Spread

State when markets are anticipated to go down then what is the Strategy of Bear Spread?

E

Expert

Verified

This strategy is deployed when the investors have a bearish attitude about the market and expect that the markets would fall in the short term. To pursue this strategy, the trader takes an opposite position i.e. sells a call option with lower exercise price while buys a call option that has the higher strike price. Therefore there is a net premium inflow initially which can be expressed as the difference of the premiums of the 2 call options. Through the use of puts also, the strategy can be structured and accordingly the payoffs as well as profits from this strategy are deduced using put options.

In case that puts are used, initially the strategy would lead to a net outflow of premium as the trader buys the put that has the higher exercise price (K2) and also shorts the put that has a lower strike price (K1). Since puts whose exercise prices are higher are more expensive in contrast to put options that have lower strike prices, there is a net premium outflow at the start which can be represented by -p2 + p1. Accordingly, at expiration, the value of this strategy can be expressed as:

V = max (0, K2 – ST) – max (0, K1 – ST).

The profits that accrue on account of the above strategy are obtained by subtracting from the value of the strategies, the net premium outflow as shown under:

Profit = max (0, K2 – ST) – max (0, K1 – ST) – p2 + p1.

In contrast to the bull spread, profits in this situation result when the prices of the stock (the underlying asset) decline. Profits from the bear spread strategy are maximized only when the short position in the put expires worthless at expiration and there is a net payoff due to the long position in the put option. This strategy has been represented in the graph below:

1902_bear spread.jpg

As can be seen from the diagram, both the profits as well as the losses are limited in this case too, like the bull spread. The only difference is that the payoff occurs only when the stock prices go down and the bearish views of the trader hold good when the options expire. It can be seen here also that the maximum loss occurs when both the options expire worthless and are out of the money and the quantum of the maximum loss is p1 – p2. On the other hand, the maximum gain that occurs can be quantified as:

Maximum profit = K2 – K1 – p2 + p1.

Like the earlier case, it is essential to ensure that the differences in the strike prices of the options exceed the net premium which is paid at the onset to implement the bear strategy. In case of bear spread with calls, the profit occurs only when both the options expire worthless and this is feasible only if the stock price declines during expiration of the option. 

   Related Questions in Corporate Finance

  • Q : CAPM-Project Evaluation and Risk

    UCD Vet Products – a hypothetical publicly traded corporation (UCDV) — is considering investing in a new line of equine DNA analysis technology for race horse breeders. The project will yield the net cash flows listed in the table below. Assume that this p

  • Q : What are capital investment The capital

    The capital investment appraisal techniques such as NPV, IRR, ARR, PV and Time value of money have become irrelevant post Celtic Tiger. Due to the depth of the recession companies do not have budgets to invest. Discus First use this information when you are writing this essay: 1.&

  • Q : Problem on rules of the International

    RainFlower Trading Limited is a wholesaler of electronic calculators in Hong Kong. It has been importing goods from a Philippine manufacturer for eight years. The Philippine manufacturer had accepted payments in advance in the past. Recently, because of political turm

  • Q : Explain useful properties of

    Explain useful properties of low-discrepancy sequence theory or quasi random number theory.

  • Q : Finance A middle income worker, with a

    A middle income worker, with a dependent spouse older than the normal retirement age, retired in January 2004. In the year prior to retirement, her gross monthly earnings were $1,500. Her Social Security pension benefit is $1,000 per month. Prior to retirement, she was subject to total taxes on her

  • Q : Which taxes do I have to use for

    Which taxes do I have to utilize when calculating Free Cash Flow (FCF) – is this the medium tax rate or the marginal tax rate of the leveraged company?

  • Q : Commercial Banking Assignment Part I

    Part I Guidelines and requirements: The questions in Part I of this assignment are based on the materials covered in Units 1 and 2. Please write a short-ess

  • Q : Determine the future value What would

    What would the future value after 5 years of $100 be at 10% compound interest?

  • Q : Explain Cost of capital aspect Cost of

    Cost of capital aspect: Estimation of WCR is beneficial from the point of view of cost of capital too. A sound working capital position is beneficial from the point of view of both owners and lenders of the company. A sufficiently positive position me

  • Q : Strategy of Bear Spread State when

    State when markets are anticipated to go down then what is the Strategy of Bear Spread?