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Bear Put versus Bear Call

This article shall briefly look at the difference between a Bear Call spread and Bear Put spread. To learn the intricacy of verticals, please review our article on that topic that was published previously.

A Bear Put and Bear Call are both bearish vertical spreads. The first one is a debit spread, and the latter one is a credit spread. In which case would one make more sense to trade over the other? It depends on the implied volatility (IV). If the IV is high then it is better to be a seller (credit spread), but if the IV is low it is better to be a buyer (debit spread). Let us focus on a specific underlying, XEO, and explore it in greater detail. The reason why XEO was selected is because it is a European Style option. We cannot possibly get assigned until expiration, even if we are dead wrong. However, this does not mean that we should ignore what the price action is doing and where the supply zones are located. As of the writing of this article, 12/27/2011, there is possible resistance at 575. Now let us look at the Implied Volatility reading for XEO at $ 574.74 [Resistance was at 575].

52 week High Historical Volatility Current Implied Volatility 52 week Low Historical Volatility
41% Approx 18+/- % 6%

Looking at the table above, we clearly see that in the current environment, XEO’s IV is only about 12 percentage points off the low versus being (41 – 18) 23% away from the 52 week high. In short, a Bear Put would be the better strategy of the two. However, we said that we are going to compare the two, so let us start with the Bear Call Spread.

Bear Call Spread

Knowing that there is possible resistance at 575, we can build a Bear Call spread around that level. In the case of the Bear Call spread, we focus on the leg that needs to be sold because that leg is the driver or anchor unit. The bottom line is that we do not expect the XEO price action to go over it. The image below shows the Time and Sales of the two calls that we will use to make up our 575/580 Bear Call on XEO.

bear call spreadXEO (at $568.53) Bear Call 575/580 on 12/22/2011

To recap what is in the image above, we have created a table that explains what the spread actually is.

XEO is at $568.53 at the close of 12/22/2011

Buy (the first leg 2 steps OTM) BTO + 580 call @ – 1.50
Sell (the second leg one step OTM) STO – 575 call @ + 2.75
Net credit received + 1.25

The next image also shows the Time and Sales of these same two call strike prices but on the morning of 12/27/2011. The last 575/580 Bear Call that day was done with 16 contracts and the premium received was greater than what a trader would have received when XEO was trading at 568.53. The same trade done when XEO was trading at 574.74 brought in $1.95 since XEO was trading much closer to the sold 575 call.

bear put spread(at $574.74) Bear Call 575/580 on 12/27/2011 at 8 AM PST

The table below highlights in red the reason why the premium went up; the price is closer to the sold strike so the 575 strike is now at-the-money and there is more inherent risk in selling it.

XEO is at $574.74

12/27/2011 at 8 AM PST

Buy (the first leg one step OTM) BTO + 580 call @ – 1.50
Sell (the second leg one step ATM) STO – 575 call @ + 3.45
Net credit received + 1.95

Bear Put Spread

Having looked into a 575/580 Bear Call spread, let us move on to the 575/580 Bear Put spread. If we speculate that XEO will NOT close above 575 then we could look at the in-the-money (ITM) puts. The option chain in the image below shows what the values were at 8 AM PST on 12/27/2011.

options chainXEO Option chain

If we were to do the same option expiration cycle, December Quarterly with three days left, the sale of the 575 put would bring in 3.60 while the purchase of the 580 put would be 7.70. The total spread would cost us (7.70 – 3.60) 4.10, while the spread is five points (580 put – 575 put). In this case, we are risking 4.10 to make 0.90 cents.

XEO is at $574.74

12/27/2011 at 8 AM PST

Sell (the second leg) STO – 575 put @ + 3.60
Buy (the first leg) BTO + 580 put @ – 7.70
Debit – 4.10
Possible Max Profit + 0.90

The rate of return is (0.90/4.10) 22% in the next three days. However, let us keep in mind that the Bear Put spread is not a credit spread where we pay less commission because we might be leaving some of the option to expire worthless. With debit spreads we are paying a total of 4 commissions, two to get in and two to exit. Those commission costs need to get subtracted from the profit made before one gets excited about the possibility of a 22% return in the next three days. Assuming that one has a greedy broker who charges $25 for the spread entry and $25 for the spread exit (regardless if it is one contract or ten contracts) then that is 0.50 in total that needs to get subtracted from the profit of 0.90. Ouch. If the 575/580 Bear Put spread was done with a single contract, the broker makes more than the trader does. The Broker’s profit, with no exposure to the market, is 0.50 while the trader’s profit, with market exposure, is only 0.40. Go ahead make your selection: credit or debit.

In conclusion, there is never a shortage of Broker/Dealers (B/D), but there is always a shortage of wise option traders. Keep in mind the commission cost when figuring out your possible rate of return. Make sure that it is subtracted from the profit regardless if the spread trade was a Bear Call or Bear Put; a credit spread or a debit spread. The B/D always fattens their purse and it is never a zero sum game (what one wins the other side has lost). The B/D are ultimately winners so go after the lowest possible commission structure you can get but do not compromise the value of the data feed that you receive. After all, trading decisions are based on that data feed. Keep your trading in the green and do not oversize your positions.

– Josip Causic

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.