Puts in a Bearish Strategy | Calls in a Bearish Strategy |
Bearish Put Spread Strategies | Bearish Call Spread Strategies |
Puts in a Bearish Strategy
When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.
An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits.
The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option.
The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option.
An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option.
Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position.
For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.
The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option.
Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position.
The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even.
An increase in volatility will increase the value of your call and decrease your return.
When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.
A vertical put spread is the simultaneous purchase and sale of identical put options but with different exercise prices.
To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a lower exercise price. The trader pays a net premium for the position.
To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.
To put on a bear put spread you buy the higher strike put and sell the lower strike put.
You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread.
An investor with a bearish market outlook should: buy a put spread. The "Bear Put Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.
The investor's profit potential is limited. When the market price falls to or below the lower exercise price, both options will be in-the-money and the trader will realize his maximum profit when he recovers the net premium paid for the options.
The investor's potential loss is limited. The trader has offsetting positions at different exercise prices. If the market rises rather than falls, the options will be out-of-the-money and expire worthless. Since the trader has paid a net premium
The investor breaks even when the market price equals the higher exercise price less the net premium. For the strategy to be profitable, the market price must fall. When the market price falls to the high exercise price less the net premium, the trader breaks even. When the market falls beyond this point, the trader profits.
An example of a bearish put spread.
Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scrip with a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs 90 at a premium of Rs 5.
In this bearish position the put is taken as long on a higher strike price put with the outgo of some premium. This position has huge profit potential on downside. If the trader may recover a part of the premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Higher strike price option - Lower strike price option - Net premium paid
= 110 - 90 - 10 = 10
Maximum loss = Net premium paid
= 15 - 5 = 10
Breakeven Price = Higher strike price - Net premium paid
= 110 - 10 = 100
Bearish Call Spread Strategies
A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.
To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.
To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.
To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.
An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.
The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price.
Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.
The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.
An example of a bearish call spread.
Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15.
In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows:
Maximum profit = Net premium received
= 15 - 5 = 10
Maximum loss = Higher strike price option - Lower strike price option - Net premium received
= 110 - 90 - 10 = 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100
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