Option Strategies - Part 3: Bull and Bear Spreads

Covered and protective options may be effective risk management strategies, but some feel that they’re simply not exciting enough. After all, they involve nothing more than taking a position in both the underlying stock and the option, and using that to either boost earnings or control losses. For some investors, this framework is too rigid for their risk tolerance and overall approach to options. In today’s article, we’re going to explore some more sophisticated option trading techniques and how they can be modified for different situations.?

Spreads

In finance, the?spread?most commonly refers to the difference between the?bid?(the prices offered by buyers) and?ask?(the prices offered by sellers) for an asset, hence the “bid-ask spread.” This can be used to measure the asset’s liquidity – less liquid assets, for example, typically have larger spreads as there are fewer market participants to buy and sell at different prices. Naturally, the gap between the highest buying price (bid) and the lowest selling price (ask) will widen.?

One common approach to spreads in options is buying and selling either puts or calls with the same underlying asset and expiration date but different strike prices. From there, we can extrapolate 4 strategies.

Bull Call Spread

This involves buying a call option and simultaneously selling a call option at a higher strike price with the same expiration date. The long call (with the lower strike price) is usually purchased at the money whereas the short call (with the higher strike price) is sold out of the money. The short call reduces the cost of taking on the long position since you can use the money from selling the call to partially offset the long call’s premium (because the short call is out of the money, it will be worth less than the at the money long call), but it also forgoes the long call’s profit if the stock price increases.?

Because the long call’s strike price is lower than the short call’s, if the short call becomes in the money (with the stock price rising above the strike price), then the long call must necessarily be more in the money. As a result, we have a limited range of profits, wherein both potential gains and losses are capped.

As shown in the graph above, if the stock price drops below the long call’s (green line) strike price of $39, then the greatest possible loss is the premium the investor paid for the long call. You won’t exercise that option since it’s out of the money, and the buyer of the short call (red line) won’t exercise their option either as it too is out of the money; in fact, because it has a $41 strike price, it’s even more out of the money than the long call.?

Hence, your only loss is the option premium you had to pay. But remember, you also earned a premium for selling the option with the higher strike price, so your losses are somewhat negated. That’s why the worst case scenario for the bull spread is a $2 loss whereas for the long call it’s a $3 loss.?

On the flip side, if the stock price rises above the short call strike price, then you can profit from exercising the long call and purchase the shares at a discount. However, the short call investor will also want to exercise their option, and so you’ll have to sell them the stock (that you just bought through the long call) at the short call’s strike price. Thus, the maximum profit is the difference between the 2 strike prices, minus the net premium paid. So in our above example, if the stock price rises to $42 per share, then you, through your long call, will make a $3 profit ($42 - $39 = $3). At that price, the short call investor will make a $1 profit ($42 - $41 = $1) and because you have to sell them the shares at the $41 strike price (which you acquired for $39), you profit $2 ($41 - $39).

Bear Call Spread

What if an investor feels moderately bullish about a stock? Rather than buying an at the money call and selling an out of the money call at a higher strike price, they can sell an in the money call and buy an out of the money one at a higher strike price (of course, with the same expiration date). Similar to the bull call spread, the bear call spread limits both the risk and reward, but yields a profit if the stock price drops below the lower strike price.

The benefits from the short call (red line) are somewhat offset by the premiums paid for the long call (green line) as the stock price declines below $39 per share. Say you pay $2 for a long call with a $41 strike price and earn $3 for a short call with a $39 strike price; once the stock price drops below $39, both call options are worthless, allowing you to pocket the $1 difference between the premiums for either call, as demonstrated with the bear call spread (blue line) flattening at the $1 point. Because both calls are out of the money, the actual differences in strike prices don’t matter – if they’re not being exercised, then the net earnings from the bear call strategy boils down to the differences in premiums paid and received.?

On the other hand, if the stock price rises above the higher strike price to say, $43, both calls will be in the money and will therefore be exercised. At that point, the long call simply breaks even whereas the short call loses $1. Hence, the final loss is $1. Alternatively, you could take the difference between the long and short call strike prices ($39 - $41 = -$2), and then add the net premium (-$2 + $1 = -$1).?

Bull Put Spread

In previously discussed option strategies (here?and?here), we’ve seen that what can be done with calls can also be done with puts. Option spreads are no exception. Bull put spreads are constructed by buying an out of the money put option and selling an in the money put option with the same expiration date and underlying stock but a higher strike price. From the bull put holder’s perspective, the ideal scenario is when the underlying stock price rises high enough such that both options expire worthless. At that point, you’d simply collect the net premiums (because the short put is in the money, you’ll receive more commissions than what you paid for the out of the money put).

If the stock price rises to $43, both the long put (green line) and short put (red line) are worthless. The premium you earn from the short put, $3, minus the premium paid for the long put, $1, yields a profit of $2. Conversely, if the stock price drops to $36, the long put position, with a $38 strike price, gains $1 (remember, the $1 premium you paid delays the point at which the long put yields profit). The short put position, with a $42 strike price, loses $3 since you have to buy the $36 share at $42, but the $3 premium you received alleviates that loss. Taking the difference between these positions, we get a net loss of $2.

Bear Put Spread

Last but not least. By selling out of the money puts and buying in the money puts with a higher strike price, the bear put spread allows investors to short stocks without unlimited downside risk. Similar to the bear call spread, the bear put spread profits if the stock price slightly drops by expiration, but also forgoes any additional profit with further declines.

Here, as the stock price declines to, say, $37, the long put position (green line) gains $2 whereas the short position breaks even. As such, the bear put’s position net gain (and also maximum profit) is $2. But if the stock rises to say, $43, then the long put loses $3. This isn’t because of the difference in the stock and strike prices, but because you won’t exercise an out of the money long put, and so the most you can lose is the premium you paid for said put, in this case $3). At $43, the short put gains $1 – it’s out of the money as the stock price is well above the strike price, and so it won’t be exercised, allowing you to keep the $1 premium earned from selling out. Thus, the net loss is $2.?

Econ IRL

Every business dreams of their sales going through the roof, but most can’t find the secret formula for doing so. Perhaps one of the most effective actions is raising customer satisfaction because loyal customers generate repeated sales and engage in positive word-of-mouth marketing. This week’s?paper?investigates how internal control deficiencies are associated with customer satisfaction.?

Comparing product ratings on Amazon.com with the corresponding firm’s internal control weaknesses disclosed on Compustat, the researchers found a negative association between customer satisfaction and internal control weakness. Moreover, peripheral products, as opposed to core products, are more susceptible to internal control issues. It is likely because secondary products do not contribute significantly to profits, thus receiving less managerial attention. Firms with greater operating complexity also have a more pronounced negative association between consumer ratings and internal control deficiencies, since the additional operating complexity will likely accentuate any information latencies and coordination frictions.?

‘Till next time,?

SoBasically