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The Bear Put Spread is set up by buying a Higher strike Put while simultaneously selling a LOWER strike Put, both with the SAME expiration date.  The Bear Put Spread is a Debit Spread, meaning you will pay a higher price for the Put that you purchase than the price of the Put that you sell.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.


Bear Put Spread - GE

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).


The last post talked about buying a CALL.  Also in a previous post I described how the risk/return graph changes when we take an opposite position. 

Lets use the same GE March $5 Call (symbol GEWCE).  If you buy the Call (Long the Call) your risk/reward at expiration looks like this:

$5 March 2009 GE Call

$5 March 2009 GE Call

And if you sell the Call (Short the Call) your risk/reward at expiration looks like this:
$5 March 2009 GE Call - Short

$5 March 2009 GE Call - Short

For this example I have assumed that you can sell the option for the same price that you can buy it.  In reality, if you look at these bid/ask prices in the previous post, you can sell the option for $5.10, a 10 cent difference.  Also, because the spread is 10 cents, it MAY be possible to buy or sell this option for $5.15. 
Notice that the graph is just mirrored about the x-axis.
If GE closes below $5 at expiration, you will have a gain of $5.20, if GE closes at $10.20, you will not gain or lose anything.  As GE goes above $10.20, you will start to have a loss, with the maximum loss being unlimited.  And if GE closes between $5.00 and $10.20 at expiration, you will have some gain.
If you sell the Call, also known as WRITING a Call, you have an OBLIGATION to purchase the underlying stock, in this example GE, for $5.00 if the holder of the option exercises the option.  It is the buyer of the Option that has a choice, or option. 
I do NOT recommend writing NAKED options, because the maximum loss is unlimited.  Naked means that you do not have another position that limits the downside risk.  Understand how options work and paper trade them before taking any positions.
To be continued–

Options are a form of a derivative.  This means that they derive their value from something else.  For example, if you buy a stock, you are buying a part of a company.  You are entitled to future earnings and assets.  The company has value and that is reflected in the price of the stock.

If you buy a CALL option on that stock, you have the right to buy that stock at a certain price by a certain date.  You do not have an obligation to buy the stock, it is your choice.  There are a few variables that go into the price of the call option and for now I will keep it simple.  The main variables are the Strike Price, the Expiration Date and the Price of the Stock.

Lets look at General Electric (GE) as an example.  On February 19, 2009 GE closed at $10.04 Bid/$10.05 Ask.  The following is a list of near the money Call options that expire in March 2009.

Call Options - General Electric February 19, 2009

Call Options - General Electric February 19, 2009


If you purchased one March $5 Call (symbol GEWCE) for $5.20 (plus transaction costs) today, you would have until the March 20th (the third friday of March) Expiration date to EXERCISE the option.  If you exercise the option, you would owe your broker $5.00 (plus transaction costs) and you would own 100 shares of GE.

Why would you do this?

Perhaps you think GE is going to announce something that will make the stock rise between now and when the option expires, but you do not have the $10.06/share to buy the stock today.  This position would only cost you $5.20 today and $5.00 later. 

If GE makes an announcement and the stock falls to $4.00/share, you will have lost the $5.20/share that you paid for the option and it will expire worthless.  If you had purchased the stock, however, you would have lost $6.06, and still own a stock that could be headed lower.

Lets look at the risk/reward graph, at the expiration date.

$5 March 2009 GE Call

$5 March 2009 GE Call

If GE stock is above $10.20 (plus transaction costs) the options will produce a gain.  If GE stock is below $5, the options will expire worthless, and the maximum loss of $5.20 will be realized.  In between $5 and $10.20 the options will incur some loss,  up to $5.20.

If we compare the graph for being long (owning) a stock vs. buying a call, one can see that we have limited the downside, while maintaining an unlimited upside potential, by buying a call.

CONS:  We are giving up the dividends that occur during the time period, and the call option has a time limit.  If we purchased the $10 call (symbol GEWCF) for $1.09 and the stock were to fall to $9.99 (a fall of $0.07) the call will expire worthless and we will lose $1.09 at expiration.

Do not be disappointed yet, remember, I am trying to explain the basics before I explain more complex combinations.

To be continued—