The simultaneous sale and purchase of either calls or puts for the same underlying contract with the same expiration date but at different strike prices is needed to pull off this strategy. You can contrast a bull spread to the bear spread, only, a bull spread is utilized by investors expecting increases in the underlying security.
For an investor to execute a bear spread, the main impetus is that they expect a decline in the underlying security and not in an applicable way. They either want to protect their existing position or want to profit from the decline in security. Bear spreads that a trader can initiate are of two types – a bear call spread, and a bear put spread. You classify both of these instances as vertical spreads.
The selling or the writing of a call, in order to generate income is involved bear call spread. Also with the same expiry, a call is bought only at a higher strike price to limit the upside risk. A credit to the trader’s account will be result of this strategy.
Bear put spread, on the hand, involves buying one put simultaneously in order to profit from the expected decline in the underlying security. Then selling or writing, with the same expiry another put, only at a lower strike price in order to generate revenue to offset the cost of buying the first put. A net debit to the treader’s account is the result of this strategy.
Ratios, such as, buying one put in order to sell two or more puts at a lower price than the first, can also be involved in bear spreads. It will lose of the market rises, since it is a spread strategy that pays off when the underlying declines. The loss, however, will be capped at premium paid for the spread.
Some benefits and drawbacks of bear spread are – For every market condition, bear spreads are not suited. In markets where the underlying asset is not making a large price jump and is falling moderately is where the bear spreads work the best. Also, bear spreads can also cap possible gains even when they limit potential losses. The pros are –
- They limit losses.
- The cost of option-writing is reduced.
- They work in moderately rising markets.
The cons are –
- It limits gains too.
- There is a risk of bull call spread, meaning a risk of short-call buyer exercising option.
The main takeaway here is that massive profits can be achieved through bear spreads if the underlying asset is below or closes at the lower strike price.
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