Today, we're going to talk about bull and bear spreads. This week we've already learned about buying puts and calls. Now we're going to build off of our previous knowledge and talk about spreads. Generally, the bull spread is a strategy that uses calls. A bear spread, on the other hand, uses puts. We will start by talking about bull spreads.
What is a bull spread? A standard bull spread requires the purchase of a call and the sale of a call with a higher strike price. Doing this limits profit potential, but because you take in the premium for selling the call with the higher strike price, your downside is limited.
So when should you buy a bull spread over a simple long call? Generally, bull spreads underperform long calls in a rising market. However, as expiration gets near, or when the position does not move in your favor, a bull spread is superior. Personally, I like bull spreads because they risk less capital than a simple long call. However, because I momentum trade, I generally just purchase long calls.
Another reason bull and bear spreads are attractive is that they take advantage of time decay. Because you are short a call at the same time that you are long a call your overall time decay is significantly less than were you just long a call. This is especially nice during option expiration week!
Now, let's introduce the bear spread.
What is a bear spread? A standard bear spread requires the purchase of a put and the sale of a put with a lower strike price. Doing this limits profit potential, but because you take in the premium for selling the call with the higher strike price, your downside is limited.
Conceptually, bull and bear spreads share the same perks, and suffer from the same pitfalls. We'll talk more in depth about the advantages and disadvantages of different spreads in the next post. After that, we'll discuss credit and debit spreads, and other spreading strategies.
Until then,
Spencer Sundahl
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