Trading Spreads and Straddles

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Bear Spread A bear spread is an option strategy where a call is purchased and a call of a lower strike price on the same stock is sold. Both calls must have the same expiration date. A bear spread can also be established by using put options, in which one put is purchased and another put with a lower strike price is sold. Again, both strikes must have the same expiration date. These option strategies are called "bear spreads" because they are used by traders who are bearish on a stock, yet want limited risk. Bear spreads may require higher commissions since they involve buying or selling multiple positions. Since bear spreads are contract-neutral, (the position is short the same number of contracts it is long) the profit or loss is limited. When you buy a put bear spread, the maximum loss possible is the net amount paid. When you sell a call bear spread, the maximum loss is the strike difference, less the net premium received from the original sale. Depending on which strikes are traded, bear spreads can also be used to profit from lack of stock price movement. Consider this example: Stock XYZ is trading at 53.50. An option trader sells the near-term 50 call and buys the near-term 55 call for a net credit of $270. If XYZ is at or below 50 on expiration, the trader will realize a profit of $270. If the stock rises above 55 before expiration, the trader will realize the maximum loss of $230. Call Bear Spread Example (XYZ=53.50) Sell 1 XYZ Jan 50 call @ 5.70 $470 Buy 1 XYZ Jan 55 call @ 2.00 $200 Total credit = $270 Maximum loss = $230 Maximum profit = $270 The most that can be lost is the difference between the strikes, or $500, less the credit received of $270. Thus the maximum loss is $230. The maximum profit, which would occur if XYZ closed below 50 on expiration, is the credit received, or $270. Bull Spread A bull spread is the opposite of a bear spread. The margin costs and risk characteristics of bull spreads are the same as those of bear spreads. Bull spreads are used when traders are bullish yet want limited risk. Like bear spreads, these strategies may require higher commissions since they involve buying or selling multiple positions. Examples of bull spreads include buying a call and selling a call of a higher strike of the same expiration and same stock. Or, one could sell a put bull spread by selling a put and buying a put of a lower strike. Put Bear Spread Example (XYZ=63) Sell 1 XYZ Jan 60 Put @ 1 $470 Buy 1 XYZ Jan 65 call @ 2.75 $200 Total debit = $175 Maximum loss = $175 Maximum profit = $325 In the example of buying the put bear spread, the maximum profit is the strike difference ($500) less the premium paid, or $325. The maximum loss is the premium paid, or $175. Straddles A long straddle is an option strategy in which a call and a put of the same strike, month and underlying terms are bought. This position is called a straddle since it will profit from a considerable change in the stock price in either direction. Though the long straddle has theoretically unlimited profit potential and limited risk, it should not be seen as a low-risk strategy. Options may lose their value very quickly, and in the case of a straddle, there is twice the amount of erosion of time value as compared to the purchase of a put or call. The short straddle is the opposite of a long straddle. This position has unlimited risk and limited profit potential, and hence is only appropriate for the experienced investor with a high tolerance for risk. The short straddle will profit from limited stock movement but will suffer losses if the underlying stock moves substantially in either direction. Both long and short straddles will attract higher commissions since they involve buying or selling multiple positions. Long Straddle Example (XYZ=54.75) Buy 1 XYZ Jan 55 call @ 5 $500 Buy 1 XYZ Jan 55 put @ 3.70 $370 Total cost = $870 Maximum loss = $870 Maximum profit = unlimited   Short Straddle Example (XYZ=54.75) Buy 1 XYZ Jan 55 call @ 5 $500 Buy 1 XYZ Jan 55 put @ 3.70 $370 Total cost = $870 Maximum loss = unlimited Maximum profit = $870 Look at the examples above. The maximum that can be lost in the first example is the amount paid, or $870. The potential profit is unlimited. For every point XYZ moves above 63.70 or below 46.30, this position will profit $100. In the second example of selling a straddle, the maximum profit is the premium received, or $870. The maximum loss is unlimited, and the position will lose $100 for every point that XYZ moves above 63.70 or below 46.30. Important Note: Trading options involves risks and is not suitable for everyone.