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“Bear Spread” Stock Option Investment Strategy

By: , dated January 25th, 2013

Stock options are contracts that give holders the right (but not the obligation) to buy or sell 100 shares of stock at a set price by the expiration date of the contract. When the holder exercises a “call option”, they are obligating the original writer (seller) to sell 100 shares of stock at the strike price. A “call option” is purchased by an investor who believes that the price of the underlying stock will rise before the expiration date – to at least the listed strike price. A “put option”, on the other hand, is purchased by an investor who thinks that the underlying price of stock will drop before the expiration date. Therefore, the holder of a put option can sell the 100 shares of stock an earlier, higher price, should the price drop as anticipated. The particular stock option strategy you use (for both call and put options) will depend on the overall trend of the market.

Bear markets are most common during recessions. But, like all phases of the economic cycle, there is always a period of transition. For instance, an investor may believe the market to still be in a bear cycle (and expect overall downward pressure on stock prices), but also believe that things are improving – to the point that prices will either cease falling or at least fall at lower rates. For investors who think the market is still in a bear cycle, but close to emerging into a neutral, or even bull market, a “bear spread” stock option investment strategy may be the best.

The “bear spread” strategy can be used for both call and put options. For those with call options, the idea is to buy an option (with a strike price 1) while also writing an option that has a lower strike price
(strike price 2) – with the result being a net credit. But, for those investors with put options who may want to buy a put option at a higher strike price while also selling a put option at a lower strike price, the result is a net debit.

Both potential profits and losses are limited using the bear spread stock option investment strategy. The maximum profit level is attained in this strategy when the final stock price is at, or below, strike price 2 for the option that was sold, be it a put or call option. For those investors with call options, this maximum profit level will be the net initial credit. If you were using put options, this total profit is limited to the difference between strike prices, minus the initial debit.

The maximum loss of the bear spread strategy is reached when the stock rests at or above the strike price 1 during the time of expiration. For those with call options, this maximum loss will be equal to the difference between strike price 1 and strike price 2, minus the initial credit. For those with put options, maximum loss is equal to the initial debit.

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