Option Trading 101: Bearish Spreads (Excel) transcript

Hello everyone, and welcome again to Neddle, the best platform around for distance learning in business, finance, economics, and much, much more. My name is Seva, and today we are continuing our crusade down through the realm of option trading. Uh we have already discussed simple option trading strategies and bullish spreads using calls and puts. Today, we are covering the last uh bit in terms of simple option trading strategies by investigating bearish spreads.

What to do if you are attracted ultimately to the payoff structure of a simple long put or a short call, but you want to uh slightly tweak the payoff structure to reflect your initial forecast, or to hedge yourself against the infinite downside? We are still investigating the case of Tullow Oil, the uh British oil company that had uh a lot of problems with management and dealing with ever-falling oil prices. So, a bearish perspective on this company is more than justified.

And uh initially, we've investigated uh two simplest option trading strategies based on Tullow Oil, which were a long put and a short call. Uh for a uh long put, again, uh what you might want to do in case of this company is you might have a downward limit on your forecast. So, you believe that the price will go down, and you indeed have the forecast that the price will go down by a lot, but you do not believe that the price will go down below a certain limit, a certain threshold.

So, in case of the long put, you simple long put, you profit ever-increasingly from the share price falling further and further down below. But, for example, if you believe that the price would not fall below 50 or 40, you could um short a put at exactly that strike price that corresponds to the downward limit of your forecast. And that's how you could alleviate a part of your fixed downside that you've undertaken by longing a put option in the first place because you would receive a premium for that short put.

And you would obviously forego your unlimited upside, but you would reflect your beliefs, your forecast about the dynamics of the share price more precisely. So, that's exactly what we're going to do in case of the long put. And the bearish spread based on puts. In case of the short call, the situation is very similar uh, to the situation that we investigated in the last video. Uh, short calls as any naked short option have unlimited downsides.

And if the share price increases contrary to your forecast, you might lose unlimited amounts of money potentially. So, investors are generally not comfortable with that. So, what you could do is you could long a call at a particular strike price that's higher than the initial strike price and cap your downside at some plausible spot to the right of 60 pence per share, that being the strike price of the original short call.

Obviously, that wouldn't go for free. Insurance and hedging are expensive. So, you would have to pay the premium for the long call and that's what going to drive your fixed upside if the price stays the same or goes down, the core of the short call, uh, it would draw it down to the magnitude that corresponding to the premium of the long call that you have to purchase. So, without further ado, let's investigate it in terms of payoffs and graphical representation, shall we?

So, for the uh, original long put, the situation is very similar. Um, if the share price is below the strike price, so the option is in the money, the puts are exercised because we as the holder of the put can sell Tullow Oil at 60 p per share having bought it at whatever the price was on the market. If it was lower, we would on gross benefit from longing the put. If the put option moves out of the money, then it's not beneficial to exercise that because we could sell at a better deal than 60 p per share on the market, so zero.

And to move from gross payoff to net payoff in case of long puts and long options in general, we need to subtract the premium. Because we are buying the option, we are holding the option, and we have provided someone with a premium to get this optionality to transfer our risk onto someone else. So, that's the typical payoff structure of the long put, every increase in upside when the price goes down, and fixed downside when the price goes up.

Uh, let's modify our payoff structure of the long put by using the bearish spread with puts. Uh, having shorted a put at a lower strike price would provide for the downward limit on our forecast. Let's assume that we believe that the price will go down by a lot, but it would not decrease below 50 p per share because well, that's a fundamental valuation we've obtained using some model, or that's an analyst consensus, or we have spotted some support lines using technical analysis, uh, and so on and so forth.

So, that's how we can come up with this target that you would use to uh, inform your decision on your spread, either bearish or bullish. So, if we believe that the price would not go further down than 50 p per share, it's beneficial for us to short a put at that particular price, and that would cap our upside if the price goes further down, but it would mitigate partially our downside if the price goes up. So, the payoff of the short put, if the share price is lower than the strike price, so the put option is in the money, it's being exercised, but now it's not being exercised by us, it's being exercised by someone else.

So, they have the opportunity to sell the stock of Tullow Oil to us at 50 p per share and we then can only sell it at the market price. So, we receive the market price and we have to pay the strike price. So, we are on gross losing. And if the option moves out of the money, then it's not being exercised and the gross payoff of it is zero. And here, as we are the on the shorting side of the option, we're the writer of the option, we have to add the option premium to move from gross payoff to net payoff because that's what we receive for providing this optionality, this right to someone else.

So, we're taking the risk and someone else is getting rid of the risk. They have to pay for it and we receive the premium. So, that's the payoff structure. And in case of the short put, very naturally, unlimited downside when the price goes down, finite upside when the price goes up. And then, again, the total payoff of any option spread is the sum of net payoffs of all options that go into the spread. So, now we can see how our payoff is formed.

We can see that we effectively capped our upside at 4.5 p per share. So, as the share price goes below 50 p per share, we're no longer gaining any any more because we have shorted a put at 50 p per share and the downside of the short put and the upside of the long put cancel each other out. Then, we continue to have uh limited downside when the price goes up, but this downside is smaller because it's compensated partially by the premium we've received by shorting uh a put option at the lower strike price.

And if we look at it graphically, we can see that the initial payoff structure of the long put, the blue line, is being first of all capped at 50 p a share, but in return for that, we are shifting it a little bit upward by the amount of the premium we received from shorting a call at 50 p a share. Now, um let's consider a bearish spread using calls. Again, the heart, the meat of the bearish spread using calls is obviously a short call.

That's the default um low volatility bearish strategy, uh but uh you might be uncomfortable with the unlimited downside that you're exposed to when shorting a call. So, you can uh long a call at a higher strike price, uh having to pay um slightly less of a premium, so your upside when the price stays the same or goes down will remain positive, and your downside when the price moves up and further up higher than the strike price of the call that you decide to long, it will be capped um at this level.

So, let's consider the payoffs of those respective short calls and long calls. So, for the short call at um strike price of 60, if the share price is lower than the strike price, so the option is in the money, call options are not exercised because uh our counterparty could have bought tallow oil at for a better deal on the market. And um as it moves out of the money, as the share price is higher than the strike price, then what they could do is they could buy it from us at 60 pence per share and sell it for the higher price on the market.

So, they would be interested in exercising their optionality. What it means for us is that we would have to buy the stock of total oil on the market and then sell it at 60 pence per share. So, we would receive 60 pence per share and we would pay whatever the market price is and given the fact that our counterparty wants to exercise it, we know that it's already higher. So, on gross we are losing if our short call is being exercised by our counterparty.

But, good news here. If we want to move from the gross payoff to the net payoff, if we've shorted the call, we need to add the premium because that what we have received from our counterparty. So, that's the payoff structure of the short call. It's very familiar to you already. Fixed upside when the price goes down and ever increasing downside when the price goes up. And that's exactly what we want to deal with using our spread.

We want to long a call at the strike price of 70, pay a lower premium and eliminate our downside when the price moves above 70. So, for a long call, if our share price is lower than the strike price, we have no interest in exercising our call option because we could have bought for a lower price on the market. And if the share price goes above the strike price, the call option moves out of the money, it's becoming exercised because we can buy it for the strike price and sell it for the market price that is higher naturally.

So, the market price minus the strike price, that's our gross payoff. In that case, to move from the gross payoff to the net payoff, we need to subtract the option premium because we have um longed the option. We are holding it. We bought it. So, the premium goes out of our pockets to someone else's pockets. So, enforcing that, we can see a typical payoff structure for long call. Fixed downside when the price goes down, ever increasing upside when the price goes up.

Now, to get the spread payoff, we need to sum the net payoffs of all the options that go into the spread. And we can figure out, we can verify that we've achieved what we were trying to do. We have capped our downside if the price moves below the strike price of the option of the call option that we longed. So, if the um share price moves below 70, our uh payoff is capped at minus 8.5 cents per share, but to provide for that, we have to limit our upside uh drastically from 5 and 1/2 pence per share to just 1 and 1/2 pence per share.

And if we look at it graphically, we can see how it all ends up. Uh we see that that was the original short call that was the essence of our a bearish spread using calls. We have uh modified our payoff structure by including a long call with a strike price of 70 pence per share. Our payoff chart has moved 4 pence down, but in return for that, we have eliminated the unlimited downside if the share price moves above 70 pence per share.

And um that's all there is for simple option trading strategies and spreads, either bullish or bearish. In the videos to come, we'll be discussing uh more advanced strategies that can be used if you are neutral on the direction, if you have no idea whether the price will go up or down, if you are neither bullish or bearish, but you have a very precise knowledge about what the volatility will be. First, we'll deal with high volatility strategies, and then we'll move on to low volatility strategies.

And, surprise surprise, after that, you'll be a master of option trading. As for now, leave a like under this video. Please subscribe if you find my materials helpful, and stay tuned. Thank you very much.