Compositedge E-learning- Options Strategies

Protect your downside risk by implementing bull- bear vertical spreads

 

Vertical spreads generally comprise of buying and selling options of the same underlying with similar expiration dates but at different strike prices. These strategies can be either characterised as debit spreads if the premium paid is greater than the premium received or credit spreads which is arrived at by calculating the difference between the two strike prices and the premium received.
Used as a directional play, the strategy has limited risk and is widely implemented in both bullish and bearish markets. The delta of a vertical spread strategy will remain unchanged irrespective of the movement of the underlying and the cash outlay is either positive or negative depending on the net premium paid minus the premium received.

Vertical spreads can be categorized into
Vertical bull spreads-
Are used as alternatives to buying call options or selling/ writing put options. Traders generally implement this strategy when they are moderately bullish on prices and/ or volatility in the underlying security.

  • Bull call spread

Involves buying either “In the Money (ITM)” or “At the money (ATM)” calls and simultaneously selling “Out of the Money (OTM)” call options.
Max gain- Restricted to the difference between the two strike prices minus the net premium paid.
Max loss- Limited to the difference between the premium paid for the long call and the premium received for the short call option.

 

Payoff diagram of a Bull Call Spread


Source: Compositedge- Protrader terminal

 

  • Bull put spread

Involves selling either “In the Money (ITM)” or “At the money (ATM)” puts and simultaneously buying “Out of the Money (OTM)” put options.
Max gain- Limited to the difference between the premium received for the short put and the premium paid for the long put option.
Max loss- Restricted to the difference between the two strike prices minus the net premium received.

 

Payoff diagram of a Bull Put Spread


Source: Compositedge- Protrader terminal

Bull call spreads are the preferred choice if you’re expecting a large upside move on the underlying security following an event. However, if you forecast the upside on the underlying to be restricted, the bull put spread should be your primary choice.

Vertical bear spreads-
Are used as alternatives to buying put options or selling/ writing call options. Traders generally implement this strategy when they are moderately bearish on prices and/ or volatility in the underlying security.

  • Bear call spread

Involves selling either “In the Money (ITM)” or “At the money (ATM)” calls and simultaneously buying “Out of the Money (OTM)” call options.
Max gain-Limited to the difference between the premium received for the short call and the premium paid for the long call option.
Max loss- Restricted to the difference between the two strike prices minus the net premium received.

  • Bear put spread

Involves buying either “In the Money (ITM)” or “At the money (ATM)” puts and simultaneously selling “Out of the Money (OTM)” put options.
Max gain-Restricted to the difference between the two strike prices minus the net premium paid.
Max loss- Limited to the difference between the premium paid for the long put and the premium received for the short put option.

 

Payoff diagram of a Bear Put Spread


Source: Compositedge- Protrader terminal

Bear put spreads are the preferred choice if you’re expecting the underlying security to drop significantly following an event. However, if you expect the downside on the underlying to be limited, the bear call spread should be favoured.

Risk- Although vertical spreads limit your risk in the event of adverse price movements, the profits too are restricted. The max profits that can be earned from a debit vertical spread is the difference between the two strike prices and the premium paid. Likewise, the max returns from a credit vertical spread is the premium or the credit received.

Reasons to use vertical spread strategies- Vertical spreads are typically used to profit from directional moves by risk averse traders instead of simply buying or writing calls and puts. The max loss from a debit vertical spread is the excess premium paid while the max loss from a credit vertical spread is the difference between the two strike prices minus the credit received. In volatile markets, option premiums are generally expensive. Since vertical spreads are a combination of long and short options, the high premium paid in buying options is more or less offset by the premium received for selling/writing options.

 

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