Bear Call Spread – Understanding Options for a Bull & Bear Market Part 4
Bear Call Spread – Understanding Options for a Bull & Bear Market (Part 4)
Let’s look at the bear side and make some different comparisons here. Bear call spread selling five of the fifty calls and buying five of the fifty-two half calls were doing this for a net total credit of $500 and that’s selling five of them. That’s one-dollar credit times a hundred times five, maximum risk here. The spread could have a full value of $2.50. We sold it for a dollar. So that would be a dollar fifty loss on five contracts times the multiplier seven-hundred-and-fifty-dollar loss. We’d expect that to be the capital requirement and breakeven of selling this call spread for a dollar is when the option we sold; in this case the $50 calls is a dollar in the money or we’ll have to give up the dollar we received in premium up front. That would be at expiration at a stock price of $51. Now, let’s take a look at the p&l graph.
Similar to before if both the shares finished below $50; we have our maximum gain, maximum profit of a dollar if the shares are above $52.50. The full value of the spread has been realized and we give back to the market the full $2.50, minus the credit received upfront, max loss is a dollar fifty. And then with the stock in between, in this case, probably going to have to do some position management. Because, if we do nothing and the stock is in between these strikes at expiration, we’ll likely be assigned on the $50 call and we will be stuck with a short shares that we may not want to have. If the stocks at $51, the $52 half call is worth nothing to us. Now, what if the stock is higher or close to $52.50? We may have to take action. It’s a good time to describe the default process known as exercise by exception.
For those of you not familiar with this, it’s very useful to know that every option holder owns the right to exercise their option at their discretion. Regardless of the moneyness of the option itself. Moneyness being, is it in the money or out of the money, doesn’t matter. The option holder can do whatever they want with it for whatever reason they want. But, if the holder doesn’t communicate any instructions to their brokerage firm the industry then has to go to a default process, which is called exercise by exception. The strike price will be compared to the last traded price on the National Exchange during regular trading hours to determine the moneyness of the option. If it’s in the money, based on that analysis by at least a penny, the option gets exercised; and if it’s not in the money by a penny, then it’s abandoned. And that happens, could say automatically, if the option holder doesn’t communicate any instructions to the brokerage firm.
It’s important to point that out. In situations where you have the stock right around your strike, at $50 or at $52.50, you want to be sure you know exactly what’s going to happen. If the stock is at a few pennies above or below the strike you sold, you might not be sure if you’re going to get assigned at all. And in order to avoid that the only thing you can do is buy the option back. Same thing, if it’s sitting right around 52 half you wouldn’t want to have the stock trading 52 half and then a few pennies higher than that and then check the market after hours and see that it gets crushed or it goes lower and you don’t want to deal with exercising your option. But without communicating your brokers firm it gets exercised anyway, so it’s always a good idea to proactively communicate instructions. When you’re on the short side, you’re not in that position. You have to decide whether or not you’re going to be assigned and then take the appropriate action.
Be aware of that dynamic of how exercise works specifically when the option and the stock price are very close to each other. That’s the bear call spread. Let’s look at the put spread that would be bearish, in this case it’s a debit spread buying the $90,$85 bear put spread for a dollar seventy. The best situation, if the stock sells off dramatically we own the $90 put that gives us the right to sell shares at $90. We sold the $85 put obligates us to buy him back there so we can capture five full dollars minus the premium we paid upfront, maximum gain is $3.30. Now, this is a debit spread. We paid a dollar seventy the most we can lose is a dollar seventy and the break-even point is when we are paid back the $1.70 at expiration. If the $90 put that we own is a dollar seventy in the money, then we retrieve our upfront cost and break even.
Here’s how it looks on the graph, maximum profit below $85. Tails off above $90, tails off as well our loss and then in between profit and loss determined by where the stock price is. Now again, what if the stock is at $85? We have to be very concerned about what’s going to happen with assignment. If it’s trading right there or within a few pennies, we own the $90 put we’re going to exercise this. But, if it’s trading right at a level where we’re not too sure about assignments, if we happen to be surprised and not get assigned, the options a little in the money at expiration and you might not get assigned. That might leave you with a position that you don’t want to have, so that would lead you more towards closing positions when there’s some level of uncertainty. It’s really not too difficult to do, but from an educational perspective it’s important that investors understand when to be uncertain. When do you need to know whether or not position management is required?
Some investors that I speak to who are newer to options think that if the option is out of the money at expiration, even if it’s by a nickel or a dime, then it won’t be assigned. Or, if it’s in the money that it absolutely will be assigned, and it’s not true as investors are likely tracking after-hours activity and also utilizing the full 60 minutes or so after the bell that their brokerage firm gives them to make that exercise decision. The comparison I want to make here between the bear call and bear put is a little different and it’s risk-reward. Notice on the bear put side, we have a maximum gain of $3.30 maximum risk of a dollar seventy. That’s almost two to one in our favor. We can make almost double of what we’re putting up to risk.
That’s the bear put spread if we look at the bear call spread, and I apologize, the numbers aren’t as clean I just wrote them differently to expand the calculation here. But just notice the comparison between the two; we’re risking more than our potential gain. We flipped it the other way around, certainly two-to-one risk-reward looks a lot better than a situation of risking more than you can gain, but there’s a reason for that and it has to do with the probability of success. When you look at the bear call spread and let’s say in this case and the stocks trading here right around $50 dollars a share. If the stock does not move and it stays neutral, we reach our max gain of a dollar.
If it drops at all, we also have a max gain. And in fact, our break-even point isn’t until we rally 2% to the upside $50 $51. A 2% move against the direction that we thought the stock was going is where our break-even point is. That’s a nice range of profitability and that’s why we have a risk-reward breakdown that looks as if it does, standing to lose potentially more than we could gain because of that advantage. Now, if you look at the bear put spread, say the stocks again right here at the strike at $90. In this case, if the stock is a neutral we have a max loss. The previous case was a max gain, and if the stock rallies up here we experience max loss, but we have some room we have to make up. A dollar seventy move, that’s what we paid for the spread, a $90 stock.
Again, that’s just about 2%. That’s coincidental by the way, but about two percent move lower that we need in our favor to get break even. It flipped from the other side, we could have experienced a 2% move in the opposite direction by doing the credit spread and reach breakeven. On the debit spread, we need a 2% move in the direction we expected, so that is why the risk-reward looks different. It’s a key difference between doing a debit spread and a credit spread.
A lot of investors and traders I’ve spoken to over the years will have strategies that define what risk-reward they’re looking for. Some want two to one, three to one, four to one, but really it comes down to how often are you successful? I’ll certainly take a one-to-one risk-reward ratio if I can be successful seven or eight times out of 10. If I’m only successful five times out of ten, but I’m getting 3 to 1 or 4 to 1 then I’m looking much better. So, it does depend on your success rate ,what risk-reward you’re looking for, but note that the credit spread will not have a risk-reward in your favor. The credit spread will, I should say, also have a much higher likelihood of probability of success. The debit risk reward spread looks a whole lot better but the likelihood of success is not as attractive, and that’s the vertical.