Bull and Bear Spreads

By: Jon Najarian

The following is an excerpt from Jon Najarian's Dr J's Little Black Book

The strategy you pick reflects the market opinion.  For example, let’s take the simplest case – a Bull Spread.  If you opt for this strategy, it’s because you have a bullish bias.  You’re buying calls because you believe a particular stock or index is going higher. 

But there is another reason to employ a bullish spread: It smoothes out the volatility, particularly when a stock has been bid strongly higher.  Ideally, you buy the lower volatility option (which carries a lower premium) and sell the higher volatility one (which has a higher premium).  When you have a bullish bias, however, it’s important to realize that you are not the only one who is bullish in the marketplace.  And with a prevailing bullish opinion, you could end up buying an option with high volatility and, as a result, an unusually high premium.  Cicso, Qualcomm, and Intel were all great stocks that had a wonderful performance for much for the 1990s and through the first quarter of 2000.  If you were bullish on those stocks, chances are the volatility would reflect the demand for those call options, especially ahead of industry events such as Comdex or companies’ quarterly earnings reports.  With all of the people betting on the upside of those stocks, if you’re trying to buy a call option, chances are you are not alone, and the excess demand has already pumped up volatility above the normal range.  In other words, you’re buying expensive options that reflect the market’s higher expectations for the company.

If you were bullish on any of those stocks and blindly went out and bought at-the-money or slightly out-of-the-money calls, chances are you would have to pay up because of the high volatility.  This is especially true ahead of earnings or stock splits when people want to speculate wildly that earnings will be much better than Wall Street expects, or that the stock will rise because of the pending split.  As a result, going ahead and wildly buying call options may be the wrong thing to do.  Why?  Because you could end up buying options with a high price that reflects the high volatility.  An alternative would be to consider buying a bull call spread, which will help you to neutralize volatility and time decay.

Let’s say Cisco is trading for $77 a share.  You buy the $80 call three months out and sell the $90 call three months out, thus creating a bull call spread.  What we’ve also done is neutralize the volatility because we’ve sold one option for every option that we’ve purchased.  Thus, if the volatility suddenly drops in Cisco – because the stock price is going down or the Street’s perception of growth diminishes – the call options that you’ve purchased are going to lose money as the volatility is reduced.  Similarly, the out-of-the-money calls that you’ve sold are going to decline in value, lessening the impact of volatility to your overall position.

For instance, let’s say you bought the July $80 call for 7 ¾ and sold the July 90 call for 4 ¼, for a net cost of $3.50 a share ($350 per spread).  At the same time, you’ve locked in a $10 spread.  The profit potential is $6.50, while the most you could lose is $3.50.  That’s nearly a two-to-one ratio of the potential reward versus the risk, which is ideal.

Now, let’s assume the volatility declined from 46 percent to 40 percent because of a drop in demand for options.  As a result, the $80 calls would experience a drop in premium from 7 ¾ to 6 5/8 while the premium on the July $90 calls dropped from 4 ¼ to 3 3/8.  You’ve lost 1 1/8 on the calls that you bought, while the calls you sold lost 7/8 – which you keep.  The net position is now worth $3.25, down $0.25 from $3.50.  But if you had just bought the calls – without doing a bull call spread – you would have faced a decline of more than $1 a share on the volatility contraction.  If you did the spread 10 times, you’d be risking a grand total of $3,500.  Rather, somebody who just bought the call 10 times is risking $7,500.

What was the reasoning behind this trade?  For one thing, you had a bullish opinion on the stock.  At the same time, you were worried about your exposure to comparatively high volatility.  If there was suddenly a 10 percent correction in one week, the risk of buying call positions without a hedge might be more than you wanted to handle.  True, when you buy a call option, the most you could lose is the premium that you paid.  But when volatility is high you may have paid more premium than you intended.  By buying a bull call spread instead, you can reduce that risk by neutralizing the effects of volatility and time decay, and still maintain a bullish stance.

Using this options model, if you move out 30 days, the call that you bought for 7 ¾ declines by 1 3/8 to 6 3/8 due to time decay.  Now, say the stock goes up from $77 to $95.  The $80 calls that you bought are worth $15 at expiration, compared with the $7.75 you paid.  If you bought only the $80 calls, the net profit on that position would be $7.25 a share.  The person who did the spread trade, however, would have captured the $10 difference, minus the $3.50 a share net cost, for a profit of $6.50 or $6,500 on a 10-lot spread.  That’s some 90 percent of the profit potential from buying naked calls with only half the investment and a fraction of the downside risk due to volatility and time decay.

That’s why the big players, the brokerage houses such as Goldman Sachs and Morgan Stanley, execute these kinds of strategies.  But it’s not a strategy that’s limited to institutions and market makers.  Retail customers frequently make this kind of spread trade when market conditions make sense.

By the same token, a bear put spread is employed when you’re bearish on a stock for whatever reason.  Maybe you think an “old economy” stock is out of favor, or you’re expecting a massive correction in a “new economy” issue.

Here’s an example: MicroStrategy Inc (MSTR) traded up to $333 on March 10, 2000.  By comparison, in early 1999 it was a $15 stock.  Even though many people thought MicroStrategy was a great company, the stock fell from the $333-range to 85 ¾ in six trading days.  There was no stock split to account for such a massive stock price drop – just a market sentiment change after the company announced it was going to restate their earnings for the previous years.

Now with the benefit of hindsight, when MicroStrategy was trading in excess of $300 a share at the beginning of March 2000, you could have decided to buy an out-of-the-money put spread to guard against a correction.  For example, you could have bought the July $250 put for $38 and sold the $200 puts for $19, for a net cost of $19 a share ($1,900 per spread).  Again, the reasoning behind this trade is that you have a short-term bearish option on the stock and you are worried about a decline in the extreme volatility.  If you bought the puts naked – without a put spread – you would be risking a defined amount of money, in this case $38 a share or $3,800.  But by doing the spread, you would have to make only half the investment and you can lessen the impact of time decay and volatility erosion.

Now, suppose the volatility declines about 10 percent.  The $250 puts that you bought would fall from $38 a share to $33 a share, a loss of $5.  The $200 puts that you sold would decline from $19 to $15, a $4 move in your favor.  The net effect is that the value of the spread trade declined by only $1 ($100 per spread), whereas if you had just bought the puts naked, you would face the $5 a share ($500) loss.

The downside of doing a spread trade is that, while it decreases the potential risk, it also reduces the profit potential.  So when MSTR fell from around $300 a share to $121, those $250 puts that you bought are worth $135 – a gain of $97 a share.  At the same time, the $200 puts that you sold for $19 are trading at $89, a $70 move against you.  The net effect is a profit of $27 a share.  Granted, that’s less than the $97 a share you would have made by simply buying the puts.  But you had far less money on the line. 

At this point, another issue comes up.  Once you’ve realized a profit on a trade, what comes next?  I always advise our traders and retail customers alike that I think it is important to take some money off the table.  You don’t wait until the last possible minute hoping to squeeze the dime out of a trade.  Because time decay and decreases in volatility can change the nature of even the simplest bull call or bear put spread and cause the trade to move swiftly against you.

Bull spreads and bear spreads are particularly good strategies when there has been some sort of disaster that results in a stock being oversold, or a swift rise that indicates the stock is overbought.  One important thing to keep in mind is that when the market makes a dramatic move one way or another, it usually reflects a panic move.  Perhaps there was some sort of disaster (rumored or otherwise) that took the stock price down sharply.  Or, maybe there was a short-squeeze in the stock and short sellers had to cover their positions, driving the price dramatically higher.  Whatever the reason for the panic, there is often an opportunity to take advantage of the imbalance that follows these wide swings in price.