Question

An investor has a bearish view of the stock, which he would like to take advantage of by constructing an option ‘spread’ strategy. Your goal is to maximize the initial cash inflow using this strategy. Suppose there exists the following options on the same underlying share of the stock. The share is currently trading in the market at $40.

1. Which options would you use for your spread strategy? Explain your answer.
2. Construct a payoff table for your option strategy. Show the payoff for individual options you use and the total payoff of the spread.
3. Draw a payoff diagram for your strategy, show the maximum and minimum level of payoff and strike price(s).

Option	Type	Strike Price
1	Call	$40
2	Call	$45
3	Call	$50
4	Put	$40
5	Put	$45
6	Put	$50

Answer 1

Answer(a):

Bear Put strategy- This strategy is taken when trader is bearish towards a particular security or the overall market. Trader uses Put options for Bear spread strategy. Two options are used:

• Buying IN-THE-MONEY Put options (Strike>Spot)
• Selling OUT OF-THE- MONEY Put option (Spot>Strike)

When trader buys the Put, he has to pay the upfront premium while when he sells the Put, he receives the premium.

• Net Debit (Premium) = Premium paid - Premium received
• Spread = Difference between the two strike prices
• Maximum Profit = Spread - Net debit
• Maximum loss = Net debit
• Break even point = Higher strike - Net Debit
• This strategy makes a profit when spot price moves below the BEP and makes loss when spot price moves above the BEP.

Answer(b):

For example; Spot price is $40, I buy an ITM Put of strike 45 at $20 and sell an OTM Put of strike 35 at $15 (Not given in the question).

• Spread: 45-35 = 10
• Net debit (Paid): 20-15 = $5

Payoff Table: At different expiry

Payoff formula = Strike price - Spot price

Spot price on expiry	Profit/Loss from Long Put	Profit/Loss from Short Put	Net Debit	Net profit/Loss
25	+20	-10	-5	+5
30	+15	-5	-5	+5
35	+10	0	-5	+5
40	+5	0	-5	0
45	0	0	-5	-5
50	0	0	-5	-5

• Maximum profit is limited to $5 that is Spread - Net debit
• Maximum loss is limited to Net debit paid.