# Strategies for a moderate price decrease

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1 Course #: Title Module 6 Strategies for a moderate price decrease Topic 1: Strategy overview... 3 Construction... 3 Limited profits, low cost... 3 Volatility... 4 Time decay... 4 Bull spread, bear spread... 4 Topic 2: Profits, losses and breakeven... 5 Maximum profit, maximum loss, breakeven... 5 Calculating your profit/loss at expiry... 5 Before expiry... 6 Topic 3: Benefits, risks and other features... 7 Put spread vs. taken put... 7 Early exercise... 7 No margins... 7 Trading costs... 8 Topic 4: Follow-up action... 9 At expiry... 9 Before expiry... 9 What if the written put is exercised? Topic 5: The bear call spread Maximum profit, maximum loss, breakeven Outcomes at expiry Why use calls? Disadvantages of the bear call spread Summary Version 2 March

3 Topic 1: Strategy overview The taken put option can be used to protect a holding of the underlying shares, or to profit from a fall in the share price. Used in the second way, the taken put offers increasing profits as the share price falls, while limiting losses to the premium paid. But what if you think the stock's price will fall only moderately. Is there a better strategy? Construction The bear spread offers a way of gaining exposure to a moderate fall in the share price but for a lower cost than the taken put. The bear put spread involves the purchase of one put and the sale of another put with a lower strike price and the same expiry. The spread is typically entered with the share price around the strike of the bought option. Example With XYZ shares at \$10.00, you enter the following strategy: Take one XYZ 1000 \$0.26 Write one XYZ 975 \$0.15 Limited profits, low cost The sale of the lower strike put means your potential profits are limited. However, the premium you receive for writing the put offsets the cost of the taken put. The net cost of the spread in our example is \$0.11. This the most you can lose. In return for accepting a cap on your potential gains, you can profit from a fall in the share price for a lower cost than an outright taken put. Version 2 March

4 Volatility The bear spread reflects a view that volatility will stay steady or increase slightly. The taken put will benefit from an increase in the volatility of the underlying stock, while the written put will be hurt. A significant rise/fall in volatility therefore does not affect the bear spread in the same way that it benefits or hurts the outright taken put. Time decay Time decay has a mixed effect on the bear spread. It hurts the taken put, and helps the written put. Because time decay benefits one leg and hurts the other, its overall effect on the bear spread is less severe than on the taken put. Bull spread, bear spread The bear spread in a falling market is the equivalent strategy to the bull spread in a rising market. Both strategies reflect a view that the share price will move moderately in the relevant direction. Both offer limited profits and limited losses. The bull spread was covered in Module 5. Version 2 March

6 Scenario 3: Share price below lower strike If the share price at expiry is below the strike of the written put, you will make the maximum profit. This is the difference between the strikes less the cost of the spread. Your profit remains the same no matter how far below the strike price of the written option the share price has fallen. For every cent the share price has fallen, the increase in value of your taken put is offset by the increase in value of the written put. Before expiry You can close out your position on market at any time - you don't have to wait until expiry. If the share price falls as expected, both put options should increase in value. The taken put should rise in value by more than the written put, due to the difference in the deltas of the two options. The net effect is that the spread increases in value. The delta of the taken put in our example might be around -0.45, and the delta of the written put around -0.3, giving a position delta of If the stock price falls by \$0.10, the spread should rise in value by about \$ Version 2 March

8 Trading costs The spread can be costly in terms of brokerage. If your broker charges 'per trade', you will pay brokerage on each leg when you enter the strategy. You will also be charged brokerage on each leg you close out. As the spread is a strategy offering limited profit potential, it is particularly important to factor brokerage into your calculations. If you are trading a small number of contracts, costs can significantly reduce your profits. Version 2 March

10 A second benefit of taking the strategy off early is that the risk of early exercise is removed. What if the written put is exercised? You must buy the underlying shares if your written put is exercised. You then have to decide whether to hold or sell these shares. If you want to sell the shares, you can: exercise your taken put, or sell the shares on market. If you do not exercise your taken put, you must decide whether to: close out the put on market, or leave it in place. Version 2 March

13 The bear put spread, in contrast, is a 'debit spread', in which your maximum loss is the premium you pay at the time of entering the strategy. No margins are payable. Version 2 March

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