A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Bear Spreads

A spread designed in such a way so as to yield profit even if the price falls is known as the bear spread. A bear spread using call options can be created by buying a call option with a higher strike price and selling a call option with a lower strike price. Both options have the same expiration date. A bear spread created by using calls involves an initial cash inflow since the value of the option sold is always greater than the value of the option bought, since the call price i.e. premium always decreases as exercise/strike price increases.

Example:

An investor buys one October call option on a share of ABB at a premium of Rs. 12 per share. The strike price is Rs.350 (X2). He also sells an October call option on a share of ABB at a premium of Rs. 71 and a strike price of Rs. 270 (X1). The payoff table (Refer Table 7) shows the fluctuations of net profit with a change in the spot price.

Table 7: Payoff from Bear Spread Using Calls

S	X1	X2	C	Payoff	Net Profit
240	270	350	59	0	59
260	270	350	59	0	59
270	270	350	59	0	59
280	270	350	59	-10	49
300	270	350	59	-30	29
320	270	350	59	-50	9
340	270	350	59	-70	-11
350	270	350	59	-80	-21
360	270	350	59	-80	-21

Payoff when S  X2, -(X2 �X1)
Payoff when X1 < S < X2, -(S � X1)
Payoff when S  X1, (0)

Here, Net profit = Payoff plus C, since C is the Cash Inflow.

Similar to the bull spread, a bear spread strategy limits both the upside potential as well as the downward risk. Investors adopt this strategy when they feel that the market will not rise and they want to limit their downside risk. A bear spread can also be created using put options by buying a put with a higher strike price and selling a put with a lower strike price, but using puts will involve an initial investment. In this case, the upside potential is limited to the difference between the strike prices and the net option premium while the downside risk is limited to the amount of net option premium.