While the bull spread seeks increases in market value, the bear spread will produce profits if the stock's market value falls. In this variety of the spread, the higher-value option is always bought, and the lower-value option is always sold.
ExampleA Bearish Idea: You open a bear spread using calls. You sell one March 35 call and buy one March 40 call. The stock's market value is $37 per share. The premium value of the lower call, which is in the money, will decline point for point as the stock's market value falls; if the stock's value does fall, the position can be closed at a profit.
ExampleGoing Pessimistic with Puts: You open a bear spread using puts.
This scenario assumes ideal conditions in which the stock's price moves the desired number of points in the perfect time frame, which enables the bear spread writer to profit. The example illustrates the ideal outcome using a bear spread. You gain more flexibility when going long using LEAPS options in the bear spread; this enables you to write several short-term puts against the "covered" longer position. The cost for the long position will be greater due to the time factor, but the potential for profit makes the entire strategy far more flexible as well.
Smart Investor TipBear strategies often are overlooked, because people tend to be optimists. Look at all of the possibilities. You can make money when the stock goes down in value, too.
[caption id="attachment_12549" align="aligncenter" width="300"] Bear vertical spread profit and loss zones.[/caption]
ExampleProfits on Both Sides: You sell one September 40 call for 5 and buy one September 45 call for 2; your net proceeds are $300. As the stock's market value falls below the level of $45 per share, the short 40 call will lose point value matching the stock's decline; the long call will not react in the same way, as it remains out of the money. As the $40 per share price level is approached, the spread can be closed with profits on both sides.
When the bear spread employs calls, profits are frozen once both sides are in the money, at least to the degree that intrinsic value changes; one side's increase will be offset by the other side's decrease. The only remaining opportunity to increase profits at that point would lie in time value premium left in the short position.
In all of these examples, the most significant risk is that the stock will move in the direction opposite that desired. Be prepared to cut losses by closing a spread in that event before the short position increases to value. You risk exercise on the short side at any time that option is in the money, and you might need to close to avoid exercise. Your maximum risk other than that of exercise is limited to the point difference between the two striking prices (minus net premium received when the position was opened, or plus net premium paid). In the preceding examples, a five-point spread was used, so that maximum point-spread risk is $500. The point-spread risk increases as the gap between striking prices changes, as shown in Table below.
Spread Risk Table
|Striking Price Interval|
|Number of Option Spreads||5 Points||10 Points|