If an investor expects a downfall/decline in the price of the underlying asset, he uses the Bear spread strategy. With this strategy, the investor can decrease the losses and increase profit.
When as an investor you are bearish that means, you believe and expect that the market; its instrument, or assets may experience a downfall.
The investors want to make a profit when the market is expected to meet of downfall or decline. With the strategy, the investors buy put or call at the same time for the underlying contract. Both of them have the same expiry date but they have very different strike prices.
Bear spread strategy is the opposite of bull spread strategy. In a bull spread strategy, the investor would think that the market would go upwards.
When the investors feel like protecting their existing position and earning more profit from the decline in the underlying security, this strategy gives the investor two options or types called bear call spread strategy and bear put spread strategy.
Both bear call spread strategy and bear put spread strategy are known as vertical spreads.
Understanding bear put spread strategy
In a put spread strategy, the investor can buy one put so that he can make a profit from the expected decline in the underlying securities, and he sells another put simultaneously with the same expiry at a lower strike price. This helps in generation of revenue offsetting the cost of buying the first option put. With bear put spread-strategy the traders get a net debit in his/her account.
Let us understand bear spread with put options by an example. If investor A wants to make a profit with the bear put-spread strategy, he would think about purchasing a put option with a higher price. Let us stay the stock trading is at $20. The option trader now thinks about buying the options using bear spread with put options worth ₹25 for ₹350 i.e. ₹3.5 x 100 contacts or shares.
Now, he will sell another option at the same ₹20 at ₹150 i.e. ₹2.0 x 100 contracts or shares.
The difference of both the total amount is ₹350 - ₹150 = ₹200. This is the amount that the investor needs to pay in total for setting up a bear put-spread strategy. The profit that the investor will make is the profit as below,
First, the difference in strike price needs to be calculated.
₹25 - ₹20 = ₹5 x 100 contracts or shares = ₹500
Now, the difference needs to be deducted from the amount.
₹500 - ₹200 (the difference between total amounts) = ₹300.
So, ₹300 is the profit made by the investor.
So, this is the bear spread with put options. It is estimated
Understanding bear call spread strategy
Opposite to the put strategy, the bear call spread strategy means selling the long call at a higher strike price and buying one short call at a specific strike price. So this bear spread call option is done to limit the upside risk. This strategy results in a credit in the account of the investor.
Let’s understand this strategy by an example. Let us say that a B investor who is bearish on the ABC stock believes that the price will go down by the upcoming month. Currently, the stock is trading at ₹30 for each share. Now the investor decides to sell a ₹24 call and decides to buy a ₹28 call. The net credit is ₹2.
If the price of the stock somehow goes down to $28 then the traders can keep the spread credit as the option expire worthlessly. But if the price of the stock goes above the price of $28 then the trader will end up with a spread credit minus. The spread credit minus is the result of ₹28-₹24 = ₹4.
The calculation of the maximum loss and maximum profit is given in the breakeven point.
So with this strategy, the investors can use the bear spread call option to collect the option premium and sell a call option. So this way with the bear spread call option, the investors can limit the risk and get profit from the declining stock prices as well as time decay.
This strategy is used best when the investors need to limit the risk considering the forecast from neutral to price fall.
The major difference between the call and put bear spread strategies is while Bear call spread considers the strike price of the short call and adds the net premium. If we talk about the put strategy which is bear put spread, then it considers the strike price of a long put and subtracts the net premium.
While the bear call spreadstrategy is for the beginners the bear put spread strategy is for the experienced.
In the call strategy, there is a specific premium to be paid while on the put strategy the investors pay a higher premium and get lower in return.
With the bear call spread, the investors can suffer the maximum loss if the price of the underlying asset increases above the striking price. With the bear put spread, the maximum loss to be incurred is limited to the net premium that the investor pays. But if the price of the underlying asset decreases below the striking price of the long put, then the loss will occur.
So bear call spread,
Investor’s Maximum Loss = Strike price of long call - strike price of short call - the net premium the investor receives
With bear put spread,
Investor’s Maximum loss = Net premium the investor pays.
The investors should know that there is a breakeven point for both of the bear spread types.
The strike price of short call plus premium investor received and the price of underlying asset is equal or same, then there is the breaking point for bread-call spread.
If the strike price of the long call minus the premium and the price of underlying asset is equal or same, then there is the breaking point for bread-put spread.
Referring to the example of investor B, the breakeven point will be calculated as below.
With the ₹2 net spread, the breakeven point is calculated as below,
₹24 strike price + $4 spread net credit = ₹26
So the maximum profit would be = ₹2
The minimum profit would be ₹28-₹24=₹4 - ₹2 = ₹2
So the bear spread strategy including both call and put options is adopted by the investor to gain the best possible profit in option trading.