Mini Chapter twelve
Bear Spread
- Generally structured as buying a higher strike put and selling a lower strike put for the same expiry and same notionals.
- As the name suggests this is a bearish expression on the underlying but also limits profits as one cheapens the option by doing a spread versus buying an outright put.
- Delta is always negative and is a mirror image as that of a bull spread as can be seen in the below chart/graph/figure.
- Same also holds true for Gamma/ vega / theta
- While both calls and puts can be used to construct bullish and bearish strategies – since puts are inherently downside expressions (as are calls for topside) they would be used more often to create bearish strategies. Same applies to calls (vs puts) for bullish expressions.
- Below is a graphical representation of a 120×90 bear spread – all of them are mirror images of the bull spread graphs.
Graph 40 – Bear Spread price across Option expiries
Source: Pandemonium.
Graph 41 – Bear Spread price across Implied Vols
Source: Pandemonium.
Graph 42 – Bear Spread Delta across Option expiries
Source: Pandemonium.
Graph 43 – Bear Spread Delta across Implied Vols
Source: Pandemonium.
Graph 44 – Bear Spread Gamma across Option expiries
Source: Pandemonium.
Graph 45 – Bear Spread Gamma across Implied Vols
Source: Pandemonium.
Graph 46 – Bear Spread Vega across Implied Vols
Source: Pandemonium.
Ratio spread
- Continuing from the bull or bear spread illustration above that describes a 1×1 purchase and sale of calls or puts, a ratio spread essentially brings together the long and short strikes in a non-1:1 ratio. As an example below we are buying an ATM 80 call and selling 1.5x notional of 100 call. Motivation of initiating this strategy (as opposed to simple bull/bear spreads) is:Â
- Sale of short strike as a multiple of purchase of long one adds leverage to the structure (cheapens the purchase of the overall structure vs just buying the lower strike call or doing a 1×1 call spread) and widens out the profit range vs what’s observed for vanilla bull/bear spreads.Â
- You can think of a ratio call spread as a combination of a long 1×1 call spread and the sale of a naked OTM call to cheapen the purchase of the spread; this would be a 1×2 ratio call spread. Similarly a ratio put spread can be seen as a combination of a long put spread and the sale of a naked put to cheapen it.Â
- Because of the net naked exposures on both strategies the wider profit margin comes with both upside and downside risks if the underlying were to trade outside the defined profit range significantly (more than eroding the premium earned). Hence for a more volatile underlying while a handsome premium is earned on the short strike, it’s also susceptible to wider swings that warrants caution while selecting the strikes. Conviction around the range-bound price action on the underlying and the leverage it brings along is a key attractiveness of this strategy. Â
- A normal call spread (ATM vs OTM Call) has a limited downside but also loses value as time passes if the underlying remains steady. If the buyer doesn’t anticipate an immediately volatile environment, they can choose to sell more of the OTM call. In our example selling 50% more of the OTM Call neutralised the current theta of the strategy (for the 1y expiry ).
- The buyer can neutralise any residual delta effectively via an offsetting trade in the underlying (sell 0.2x of the underlying notional for every 1x of the strategy notional).
Let’s graphically understand the example of a long 1x notional ATM 80 call vs short 1.5x notional 100 call (1×1.5 Call spread).
Graph 47 – Long Ratio Spread price across Option expiries
Source: Pandemonium.
Graph 48 – Long Ratio Spread Delta across Option expiries
Source: Pandemonium.
Graph 49 – Long Ratio Spread Gamma across Option expires
Source: Pandemonium.
