Introduction and Application of Futures and Options

CHAPTER 5 Introduction and Application of Futures and Options Introduction to Futures Futures Terminology Introduction to Options Option Terminology Index Derivatives Application of Futures Application of Options

125 Futures and options represent two of the most common form of Derivatives. Derivatives are financial instruments that derive their value from an underlying. The underlying can be a stock issued by a company, a currency, Gold etc. The derivative instrument can be traded independently of the underlying asset. The value of the derivative instrument changes according to the changes in the value of the underlying. INTRODUCTION TO FUTURES Definition of Futures A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On

126 the other hand, anybody could speculate on the price movement of corn by going long or short using futures. A Future is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features: Buyer Seller Price Expiry Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency. The difference between the price of the underlying asset in the spot market and the futures market is called Basis. (As spot market is a market for immediate delivery) The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost,

127 insurance premium etc., That is, if you buy the asset in the spot market, you will be incurring all these expenses, which are not needed if you buy a futures contract. This condition of basis being negative is called as Contango. Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For e.g., if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend. When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is called Backwardation. Backwardation generally happens if the price of the asset is expected to fall. It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them ie., the basis slowly becomes zero. FUTURES TERMINOLOGY Futures : Standardized contracts for the purchase and sale of financial instruments or physical commodities for future delivery on a regulated commodity futures exchange.

128 Forward Contract : A private, cash-market agreement between a buyer and seller for the future delivery of a commodity, at an agreed upon price. In contrast to futures contracts, forward contracts are not standardized and are non-transferable. Spot Market : A market where cash transactions for the physical or actual commodity occur. CME Globex : The first global electronic trading system for futures and options has evolved to become the world s premier marketplace for derivatives trading. With continual enhancements, the platform has effectively enabled CME Group, already known for innovation, to transform itself into a leading high-tech, global financial derivatives exchange. Contract Size : By definition, each futures contract has a standardized size that does not change. For example, one contract of corn represents 5,000 bushels of a very specific type and quality of corn. If you are trading British pound futures, the contract size is always 62,500 British pounds. The E-mini S&P 500 futures contract size is always $50 times the price of S&P 500 index. Specifications for all products traded through CME Group can be found at cmegroup.com.

129 Contract Value Contract value, also known as a contract s notional value, is calculated by multiplying the size of the contract by the current price. For example, the E-mini S&P 500 contract is $50 times the price of the index. If the index is trading at $1,425, the value of one E-mini contract would be $71,250. Tick Size : The minimum price change in a futures or options contract is measured in ticks. A tick is the smallest amount that the price of a particular contract can fluctuate. Tick size varies from contract to contract. A tick in the E-mini S&P 500 futures contract is equal to one-quarter of an index point. Since an index point is valued at $50 in the E-mini, one tick is equivalent to $12.50. INTRODUCTION TO OPTIONS A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date). Call options give the option to buy at certain price, so the buyer would want the stock to go up.

130 Put options give the option to sell at a certain price, so the buyer would want the stock to go down. Options are extremely versatile securities that can be used in many different ways. Traders use options to speculate, which are a relatively risky practice, while hedgers use options to reduce the risk of holding an asset. In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security. For example, because the option writer will need to provide the underlying shares in the event that the stock s market price will exceed the strike, an option writer that sells a call option believes that the underlying stock s price will drop relative to the option s strike price during the life of the option, as that is how he or she will reap maximum profit. This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise, because if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit.

131 Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a call option or a put option. A call option gives the buyer, the right to buy the asset at a given price. This given price is called strike price. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right. Similarly a put option gives the buyer a right to sell the asset at the strike price to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy. So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as premium. Therefore the price that is paid for buying an option contract is called as premium. The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs 500. On

132 expiry the price of the asset is Rs 450. A will not exercise his call. Because he can buy the same asset from the market at Rs 450, rather than paying Rs 500 to the seller of the option. The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs 600. On expiry the price of the asset is Rs 619. A will not exercise his put option. Because he can sell the same asset in the market at Rs 619, rather than giving it to the seller of the put option for Rs 600. Call Option : An option to buy an underlying asset (stock or currency) at an agreed upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has economic value, you have to pay a price, called the Premium. Example: Ebay was selling at $32/share (Oct. 27, 2006), and about 60 different options were trading for Ebay. For example, for $3.50 (premium) you could buy one call option that would allow you to buy a share of Ebay for $30 (strike Price) on or before January 19, 2007. You will exercise the option if P > $30, and you will make money if the P > $33.50 ($30 + $3.50). If P = $30, you will not exercise the option, it will

133 expire worthless and you will lose the premium ($3.50). See diagram below: Profit Call Buyer $3.50 $30 $33.50 Call Buyer -$3.50 Loss Call Writer Fig. 5.1: Payoff Diagram for January 2007 $30 Ebay call option, Premium = $3.50 Like futures trading, option trading is a zero-sum game. The buyer of the option purchases it from the seller or the person who writes the call. Options are traded in units of 100 shares. Put Option : It gives the owner the right, but not the obligation to sell an underlying asset at a stated price on or before the expiration date. Example: Ebay $35 Jan 2007 puts are selling for $3.70 (premium). If you buy 1 Ebay put, you will make money if Ebay stock P < $31.30 ($35 - $3.70). You will exercise if P < $35, you will exercise but lose money if P is between $31.30 - $35. If Ebay P > $35, put will expire worthless for buyer.

134 $3.70 Put Seller $31.30 $35 -$3.70 Put Buyer Fig. 5.2: Payoff Diagram for January 2007 $35 Ebay put option, Premium = $3.70 Two types of options: American (can be exercised any time at or before expiration) and European (can only be exercised at expiration). OPTION TERMINOLOGY Option : An option on a futures contract is the right, but not the obligation, to buy or sell a particular futures contract at a specific price on or before a certain expiration date. There are two types of options: call options and put options. Each offers an opportunity to take advantage of futures price moves without actually having a futures position. Call Option : A call option gives the holder (buyer) the right to buy (go long) a futures contract at a specific price on or before an expiration

135 date. For example, a CME September Japanese Yen 126 call option gives the holder (buyer) the right to buy or go long a Yen futures contract at a price of 126 ($.0126/Yen) anytime prior to September expiration. Even if yen futures rise substantially above.0126, the call holder will still have the right to buy Yen futures at.0126. If Yen futures moves below.0126, the call option buyer is not obligated to buy at.0126. Put Option : A holder of a put option has the right to sell (go short) a futures contract at a specific price on or before the expiration date. For example, a CMEOctober Live Cattle put gives the put holder the right to sell October Live Cattle futures at $1.24/lb. Should the futures decline to $1.14/lb., the put holder still retains the right to go short the contract at $1.24/lb. If Cattle futures move higher, the put holder is not obligated to sell at $1.24. Option Buyer : An option buyer can choose to exercise their right and take a position in the underlying futures. A call buyer can exercise the right to buy the underlying futures and a put buyer can exercise the right to sell the underlying futures contract. In most cases though, option buyers do not exercise their options, but instead offset (take the opposite position) them in the market before expiration, if the options have any value.

136 Option Seller : An option seller (i.e., someone who sells an option that they didn t previously own) is also called an option writer or grantor. An option seller is contractually obligated to take the opposite futures position if the option buyer exercises their right to the futures position specified in the option. In return for the premium, the option seller assumes the risk of taking a possibly adverse futures position. Puts and Calls : Puts and calls are separate option contracts; theyare not the opposite side of the same transaction. For every put buyer there is a put seller, and for every call buyer there is a call seller. The option buyer pays a premium to the option seller in every transaction. The following is a list of the rights and obligations associated with trading put and call options on futures. Call Buyers Call Sellers : Exercising the option results in a futures position at the designated strike price. For example, by exercising a CME September E-mini S&P 500 1290 call, the buyer of the option would then be long a September E-mini S&P 500 futures contract at 1290. If the holder of a CBOT August Soybean 15.00 put were to exercise their option, the result would be a short futures position, at $15.00/bushel, in August Soybean Futures.

137 Strike prices are set by the Exchange and have different intervals depending on the underlying contract. Strike prices are set above and below the existing futures price and additional strikes are added if the futures move up or down. Underlying Futures Contract : The underlying is the corresponding futures contract that is purchased or sold upon the exercise of the option. For example, an option on a March CBOT 10-Year Treasury Note futures contract is the right to buy or sell one such contract. An option on COMEX December Gold futures gives the right to buy or sell one COMEX December Gold futures contract. Premium : The premium is the price that the buyer of an option pays and the seller of an option receives for the rights conveyed by an option. Ultimately the cost of an option is determined by supply and demand. Various factors affect options premiums, including strike price level in relation to the futures price level; time remaining to expiration market volatility and interest rates -all of which will be discussed further. Exercise : Exercise refers to the process whereby the option buyer asserts their right and goes long the underlying futures (when of exercising a call) or short the underlying futures (when exercising a put). Assignment : Assignment refers to the obligation of option sellers to take the opposite and possibly adverse futures position to the option

138 buyers if assigned and for this risk receive the premium. Remember: Buyers exercise and sellers get assigned. Expiration Date/Last Trading Day : This is the last day on which an option can be exercised into the underlying futures contract. After this point the option will cease to exist; the buyer cannot exercise and the seller has no obligation. Note that some options expire prior to the final settlement or expiration of the underlying futures contract. For example, a 2012 CME September British pound 1550 call option will expire September 7, 2012. However, the underlying futures will expire September 17, 2012. The last trading day is the last day on which an option can be offset. Offset : The buyer is under no obligation to exercise an option on a futures contract. As a matter of fact, many traders choose to offset their option position prior to expiration. Traders will offset their option position if they wish to take profits before expiration or limit their losses. Options buyers can offset their options by instructing their broker to sell their option before expiration. An option seller can offset a position by buying back or covering a short position. Options on futures, like futures themselves, trade both on the trading floors, and on

139 the CME Globex electronic trading platform, where many options can be traded virtually around-the-clock throughout the trading week. Put Buyers Put Sellers : The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfil the terms of his/her contract. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position; much like selling a stock in the equity markets would close a trade. INDEX DERIVATIVES Index derivatives are derivative contracts which have the index as the underlying. The most popular indexderivatives contracts the world over are index futures and index options. NSE s market index, the S&P CNX Nifty was scientifically designed to enable the launch of index-based products like index derivatives and index funds. The first

140 derivatives contract to be traded on NSE s market was the index futures contract with the Nifty as the underlying. This was followed by Nifty contracts. Trading on index derivatives were further introduced on CNX Nifty Junior, CNX 100, Nifty Midcap 50 and Mini Nifty 50. APPLICATION OF FUTURE The phenomenal growth of financial derivatives across the world is attributed the fulfillment of needs of hedgers, speculators by these products. In this chapter we first look at how trading futures differs from trading the underlying spot. We then look at the payoff these contracts, and finally at how these contracts can be used by various entities in the economy. A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis. Futures Payoffs Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of futures contracts are unlimited. These liner payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

141 Payoff for Buyer of Futures: Long Futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset.he has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two month nifty index futures contract when the nifty stands at 2220. The underlying asset in this case is the nifty portfolio. When the index moves down it starts making losses. Fig 5.3 shows the payoff diagram for the buyer of a futures contract. Fig. 5.3 : The payoff diagram for the buyer of a futures contract The Fig. 5.3 shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

142 Payoff for Seller of Futures: Short Futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He/she has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells two-month Nifty index futures when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves up, it starts making losses. Figure 5.4 shows the payoff diagram for the seller of a futures contract. Fig. 5.4 : The payoff diagram for the seller of a futures contract The Fig. 5.4 shows the profit/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

143 Options Payoffs The optionally characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium however his losses are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff Profile for Buyer of Call Options: Long call - A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 2250 bought at a premium of 86.60.

144 Fig. 5.5 : The payoff for the buyer The Fig. 5.5 shows the profits/losses from a long position on the index. The investor bought the index at 2220. If the index goes up, he profits. If the index falls he losses. Payoff for Buyer Call Option : The Fig. 5.6 shows the profits/losses for a buyer of a three-month Nifty 2250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty -close and the strike price. The profits possible on this option are potentially unlimited. However, if Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

145 Fig. 5.6 : Profits/losses for a buyer of a Nifty call option Payoff Profile for Buyer of Call Option: Short call - A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying whatever is the buyer s profit is the seller s loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 2250 sold at a premium of 86.60.

146 Fig. 5.7 : Profits/losses for the seller of a Nifty call option The Fig. 5.7 shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty rises, the call option is in the-the-money and the writer starts making losses. If upon expiration, Nifty closes above the striker of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs. 86.60 charged by him. Payoff Profile for Buyer of Put Options: Long Put - A put option the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is

147 higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Fig. 5.8 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 2250 bought at a premium of 61.70. Fig. 5.8 : Profits/losses for the buyer of a Nifty put option The Fig. 5.8 shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty close. The profits possible on his option can be as high as the strike price. However, if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the extent of the premium he paid buying the option.

148 Payoff Profile for Writer of Put Options: Short Put - A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer s profit is the seller s loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying more than the strike, the buyer lets his option unexercised and the writer get to keep the premium. Figure 5.9 gives the payoff for the writer of a three month put option (often referred to as shot put) with a strike of 2250 sold at a premium of 61.70. Fig. 5.9 : Profits/losses for the seller of a Nifty put option The Fig. 5.9 shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty falls, the put option is

149 in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (since the works that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs. 61.70 charged by him. APPLICATION OF OPTIONS We look here at some application of options contracts refering to single stock option. However, since the index is nothing but a security whose price of level is a weighted average of securities constituting the index, all strategies can be implemented using index options. Hedging : Have underlying Buy Puts - Owners of stocks or equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such

150 volatility: market volatility is always enhanced for one for week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using pot options. Index and stock options are a cheap and easily implement able way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy pot options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put option bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively level. This level depends on the strike price of the index options chosen by you. Portfolio insurance using put options is of particular interest to mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall.

151 Fig. 5.10 : Buying Puts Speculation: Bullish Security, Buy Calls or Sell Puts - There are times when investors believe that security prices are going to rise. For instance, after a good budget, or good corporate results, or the onset of a stable government.how does implement a trading strategy to benefit from an upward movement in the underlying security? Using options there are two ways one can do this: Buy call options: or Sell put options We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a month time. Your hunch proves correct and the price does indeed rise, it is this upside that you cash in on. However, if your hunch proves to be

152 wrong and the security price plunges down, what you lose in only the option premium. Bull Spreads- Buy a Call and Sell another - There are times when you think the market is going to rise over the next two months however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread. How does one go about doing this? This is basically done utilizing two call options having the same expiration date, but different exercise price. The buyer of a bull spread buys a call with an exercise price below the current index level and sells a call option with an exercise price above the current index level. The spread is a bull spread because the traders hope to profit from a rise in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bull spread? Compared to buying the underlying asset itself, the bull spread with call options limits the trader s, but the bull spread also limits the profit potential.

153 Fig. 5.11 : Buy Calls or Sell Puts Bear Spreads : Sell a Call and Buy another - There are times when you think the market is going to fall over the next two months. However in the event that the market does not fall, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread. How does one go about doing this? This is basically done utilizing two call options having the same expiration date, but different exercise prices. How a bull is spread different from a bear spread? In a bear spread, the strike price of the option purchased is greater than the strike price of the option sold. The buyer of a bear spread buys a call with an exercise price above the current index level and sells a call option with an exercise price

154 above the current index level and sells a call option with an exercise price below the current index level. The spread is a bear spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a spread because it involves buying one option and selling a related option. What is the advantage of entering into a bear spread? Compared to buying the index itself, the bear spread with call options limits the trader s risk, but it also limits the profit potential. In short, it limits both the upside potential as well as the downside risk. A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Table 4.4 gives the profit/loss incurred on a spread position as the index changes. Fig. 5.12 : Payoff diagram of a Vertical Bear Call Spread Broadly we can have three types of bear spread : (1) Both calls initially out-of-money.

155 (2) One call initially in-the-money and one call initially out-of-the-money. (3) Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price.

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