Bull and Bear Spreads; Which Flavor’s for You?

Yesterday, we talked about credit and debit spreads. We learned the pros and cons of each, and today we are ready to tackle a new aspect of spreading risk with bull and bear spreads. Although, many different setups can be created, there are basically two different risk appetites that can be achieved with bull and bear spreads.

Phil and Bob Follow Buffet

Our good friends Phil and Bob have yet again discovered a trade they like. Recently, Warren Buffet's company Berkshire Hathaway has acquired a large stake in the oil giant Exxon Mobil (Stock Symbol XOM.) Warren thinks inflation will soon set in and commodity prices will soar. Bob and Phil think Warren might be right, so they have decided to take up an option position in XOM. To best take advantage of this opportunity, Bob and Phil are both going to set up bull spreads. However, Bob and Phil aren't really sure how high XOM will go. Bob, the more conservative of the two, sees 80.00 by January, a large, but realistic move for XOM. On the other hand, Phil finds such a target likely, but believes the momentum will build and it will take XOM beyond its fundamental limits, all the way to 85.00.

Bob will set up a 75.00/80.00 spread. He will buy XOM January 75.00 calls, and sell January 80.00 calls for a net debit of 1.85. If XOM is at our beyond 80.00 when the option expires in January his profit will be 3.15, a significant amount for what seems to be a reasonable trade. Phil will take a different route. Phil will buy the January 80.00 calls, and sell January 85.00 calls for a net debit of .55. If XOM is at or above 85.00 when the options expire in January, Phil will have a large profit of 4.45! A very significant profit for such a small debit, but such a profit would require a very large move. A move that is unlikely for XOM.

As you can see, bull and bear spreads come in two different flavors. When the option you buy is more than one strike price away from the current price it is considered a more speculative and aggressive position (a Phil position, if you will.) In contrast, when the option is nearest the current strike price, it is considered a standard level of risk for a bull or bear spread, and a less risky position than simply buying a call or put.

You now know a good deal about bull and bear spreads. You can set them up in a variety of ways, debit or credit, aggressive or not-so-aggressive, bull or bear. As always, practice in a virtual account before you trade such spreads in a live account, it will save you money in the long run. Next, I will introduce you to one of the most complex and important topics in the world of options: volatility. Along with this, we will talk about the calendar spread. The calendar spread is a particularly useful strategy that offers a variety of unique opportunities.

Until next time,

Spencer Sundahl