A bear spread is a bearish trading strategy with limited risk and reward for the buyer. As with a bull spread, the upside and downside of a bear spread are limited. But the upside in case of a bearish market scenario is more than the downside of a bullish market scenario. So, it benefits a trader which is expecting the market to go down.
Construction of a Bear Spread
A bear spread can be constructed using either two call options or two put options. Each of these methods is discussed below:
- A bear spread can be constructed by buying a call option with a high strike price and selling a call option with a lower strike price. The premium paid for the high strike price call will be lower than the premium received for the lower strike price call, so there will be an initial cash inflow while entering a bear spread with call options. The trader will benefit with a decrease in the underlying price because the calls will expire worthlessly and he will pocket the initial premium received.
- A bear spread can also be constructed by buying a put option with a high strike price and selling a put option with a lower strike price. The premium paid for the high strike put will be higher than the premium received for the lower strike put, so there will be an initial cash outflow while entering a bear spread with put options. The trader will benefit when the market goes down and the profit from the high strike put outweighs the loss from the lower strike put.
Irrespective of how it is constructed, the profit curve from a bear spread looks like below:
Uses of bear spread
A bear spread is a bearish trading strategy where the trader is expecting the market to move down. But, as in a bull spread, he is also risk averse and doesn’t want a large downside exposure. So he will enter a bear spread instead of buying a plane put option or selling a plain call option. The premium paid in case of buying a plain put option is more than that of a bear spread, and the maximum downside if the market moves in the opposite direction is unlimited in case of selling a plain call option.
Options, Futures and Other Derivatives by John C Hull