There are times when you think the market is going to fall over the next two months, however in the event that the market does not fall, you would like to limit your downside.
One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread.
A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Table 7.5 gives the profit/loss incurred on a spread position as the index changes. Figure 7.7 shows the payoff from the bull spread.
Broadly we can have three types of bear spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take.
The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.
As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.
One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread.
A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Table 7.5 gives the profit/loss incurred on a spread position as the index changes. Figure 7.7 shows the payoff from the bull spread.
Broadly we can have three types of bear spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take.
The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff.
As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.