Question

Question 9

Assume the options mentioned below are European style, have the same maturity date, and are written on stock MNP. Ignore any discounting between the date at which an option is purchased and the date it matures. Stock MNP costs $30 today.

1. Suppose an investor purchases a “bear put spread” (i.e. she buys one put option P₁ for $5 with a strike of $35 and sells one put option P₂ for $2 with a strike price of $30). Draw the payoff and profit of the portfolio.
   
2. What are the advantages and disadvantages of this trade? What do you suppose the investor is trying to do with this trade (i.e. what is her goal)?
   
3. Give an example of when this trade would be counterproductive (i.e. when would this trade provide payoffs that are opposite the goals of the investor).

Answer 1

Answer(a): Bear Put spread- It is a vertical spread and a bearish strategy. When an investor is bearish towards the overall market or a particular stock then he goes for Bear put spread strategy.

It involves-

• Buying an In the money (ITM) Put,
• Selling an Out of the money (OTM) or At the money (ATM) Put.
• Spread = Difference between the strike prices,
• Maximum profit = Spread - Net debit
• Max loss = Net debit (net premium)
• Net debit = Premium paid - Premium received
• Breakeven point = Higher strike - Net debit

In this question,

Investor bought an ITM call with strike price 35 at $5 and sold an ATM call with strike price 30 at $2.

Current stock price is $30

Net debit: 5-2 = $3

Spread: 35-30 = 5

Maximum profit: 5-3 = $2

Maximum loss = $3 (Net debit)

Payoff profile:

Stock price at expiration	Payoff from Long Put	Payoff from Short Put	Net Debit	Net Profit/Loss
20	+15	-10	3	2
25	+10	-5	3	2
30	+5	0	3	2
35	0	+5	3	2
40	-5	+10	3	2

Answer(b):

Advantage- This strategy involves less cost as the premium paid is offset by premium received and this strategy has limited loss that is to the extent of net premium paid.

Disadvantage- This strategy has limited profit, not good for the beginners of stock market.

Goal of Investor- Investor is bearish towards the market or stock and he wants to gain from the bearish market in near term.

Answer(c): This trade will be counterproductive when stock does not move and becomes range bound only then the premium will lose its value.