What is Bull and Bear Spread?
Bull and Bear spread are two common hedging strategies. In the Bull spread, the buyer of the spread purchases a European call option with a low exercise price and subsidizes the purchase price of the call by selling a European call with a higher exercise price. It is ensured that the expiration dates are identical for both options. While doing this all, the bull call holder expects the stock price to rise and the purchased call to finish in the money.
On the other hand, a bear call spread exactly the opposite, i.e., the sale of a bull spread. The trade will purchase the call with the higher exercise price in the bear spread and sell the call with the lower exercise price. In this strategy, the trader expects the prices to go down. As stock prices fall, the investor keeps the premium from the written call, net of the long call’s cost.
Example of Bull and Bear Spread:
Let's take the example of Bull Call Spread. Let's assume that an investor purchased a call option with a strike rate of USD 40 and a premium of USD 3 and then sells a call at a higher strike price of USD 50. If the stock price is at USD 45, let's calculate the profit as follows:
C = Max (0, ST-XL) + Max (0, ST-XH) - CLo + CHo = 5-0-3+1 = 5