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Options Spreads Explained – A Complete Guide
Every options trader should know what options spreads are and what different types of options spreads exist. If you aren’t completely familiar with options spreads, this article will definitely help you out! After reading this article, you won’t only know what an options spread is. You will also be familiarized with all the different options spreads that exist. This is very powerful because if you fully understand options spreads, you will understand ALL options strategies!
So without further ado, let’s get started.
What Is An Option Spread?
Before we get into the different kinds of options spreads that exist, it is important to understand what an options spread even is. So what is an option spread?
An options spread is an option strategy involving the purchase and sale of options at different strike prices and/or different expiration dates on one underlying asset. An options spread consists of one type of option only. This means that options spreads either solely consist of call or put options, not both. Furthermore, an options spread has the same number of long as short options.
Let me give you a concrete example to make it clear what an options spread is. The following position is an options spread:
 1 XYZ short call with a strike price of 100 that expires in 40 days.
 1 XYZ long call with a strike price of 105 that expires in 40 days.
As you can see, the justdescribed options only differ in regards to strike price and opening transaction (one call option is bought and the other one is sold).
Let’s recap the characteristics of an options spread:
 All involved options are on the same underlying asset (e.g. XYZ).
 All involved options are of the same type (call or put).
 An options spread always consists of the same number of purchased as sold options (e.g. 5 short and 5 long).
In other words, the options involved in an options spread only differ in regards to strike price and/or expiration date. This is the case for all options spreads, regardless of kind. So when I will walk you through all the different options spreads in a few moments, keep this in mind.
Even though the options involved in an options spread only differ in regards to 12 aspects, it is still possible to create a wide variety of different options spreads.
Next up, I will walk you through all the different kinds of options spreads: vertical spreads, horizontal spreads, diagonal spreads, credit spreads, debit spreads, bull spreads…
Option Spreads Visually Explained
Watch the following video for a visual breakdown of option spreads:
Different types of options spreads explained
What are vertical spreads?
Vertical spreads are options spreads created with options that only differ in regards to strike price. So basically, a vertical spread consists of the same number of short calls as long calls or the same number of long puts as short puts with the same expiration date (on the same underlying asset).

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This doesn’t leave too many possibilities. That is also why only four different vertical spreads exist, namely bull call spreads, bear call spreads, bull put spreads and bear put spreads.
These four different vertical spreads can be ordered into different categories:
 Bull Spreads: Bullish spreads (that profit from increases in the underlying asset’s price).
 Bear Spreads: Bearish spreads (that profit from decreases in the underlying asset’s price).
 Call Spreads: Spreads that consist of call options only.
 Put Spreads: Spreads that consist of put options only.
 Credit Spreads: Spreads that are opened for a credit (you get paid to open).
 Debit Spreads: Spreads that are opened for a debit (you pay to open).
A bull call spread is a bullish debit spread, whereas a bear call spread is a bearish credit spread. A bull put spread is a bullish credit spread and a bear put spread is a bearish debit spread.
Here is how the four different vertical spreads are set up:
Bull Call Spread (aka. Long Call Spread):
 1 long call
 1 short call at a higher strike price (with the same expiration date)
Bear Call Spread (aka. Short Call Spread):
 1 short call
 1 long call at a higher strike price (with the same expiration date)
Bull Put Spread (aka. Short Put Spread):
 1 long put
 1 short put at a higher strike price (with the same expiration date)
Bear Put Spread (aka. Long Put Spread):
 1 short put
 1 long put at a higher strike price (with the same expiration date)
All vertical spreads are defined risk and defined profit strategies which means that you can’t lose or profit more than a certain amount. The amount of risk and potential profit depends on the width of the strikes and on the position of the strikes in relation to the underlying’s price.
To calculate the max risk and max profit of vertical spreads, you need one calculation:
Width of Strikes × 100 − Net Credit or Debit
This calculation reveals the max risk of credit spreads (Bull Put Spreads and Bear Call Spreads) and the max profit of debit spreads (Bear Put Spreads and Bull Call Spreads).
The max profit of credit spreads equals the net credit collected to open, whereas the max risk of debit spreads equals the net debit paid to open.
Vertical spreads are directional strategies which means that they mainly profit from price movement in the underlying asset’s price. That’s also why they are called bull/bear spreads. This means that vertical spreads are a strategy principally used to take advantage of price movement. Nevertheless, implied volatility and time still can influence vertical spreads to a certain extent.
What are horizontal spreads?
Horizontal spreads are options strategies that consist of the same number of long as short options that only differ in regards to the expiration date (on the same underlying asset). In other words, the options involved have the same strike price but a different expiration date.
Let me give you a concrete example to explain what a horizontal spread is:
 1 long ABC call with a strike price of 50 that expires in 29 days (frontmonth).
 1 short ABC call with a strike price of 50 that expires in 57 days (backmonth).
Just like with vertical spreads, there only exist four different kinds of horizontal spreads, namely short call calendar spreads, long call calendar spreads, short put calendar spreads and long put calendar spreads. As you may have noticed, all of these spreads are calendar spreads. That is also the reason why horizontal spreads also are referred to as calendar spreads.
The setup of these four different calendar spreads is relatively simple:
Long Call Calendar Spread:
 1 short call (frontmonth)
 1 long call at the same strike price (backmonth)
Short Call Calendar Spread:
 1 long call (frontmonth)
 1 short call at the same strike price (backmonth)
Long Put Calendar Spread:
 1 short put (frontmonth)
 1 long put at the same strike price (backmonth)
Short Put Calendar Spread:
 1 long put (frontmonth)
 1 short put at the same strike price (backmonth)
Calendar spreads are mainly used as a strategy to profit from changes in implied volatility and from time decay. For instance, long calendar spreads profit from increases in implied volatility.
Generally, calendar spreads aren’t a very directional strategy. But depending on the strike selection, calendar spreads can be set up more and less directional.
What are diagonal spreads?
Diagonal spreads are a combination of vertical and horizontal spreads. A diagonal spread is a strategy that consists of the same number of long as short options that have different strike prices and different expiration dates.
The options used in vertical spreads only differ in regards to strike price, the options used in horizontal spreads only differ in regards to the expiration date and the options used in diagonal spreads differ in regards to both strike price and the expiration date.
There are many different ways to set up diagonal spreads. But here are a few concrete examples of possible diagonal spreads.
Diagonal spread example 1:
 1 short XYZ call with a strike price of 185 that expires in 27 days (frontmonth).
 1 long XYZ call with a strike price of 190 that expires in 55 days (backmonth).
Diagonal spread example 2:
 1 long ABC put with a strike price of 78 that expires in 20 days (frontmonth).
 1 short ABC put with a strike price of 72 that expires in 48 days (backmonth).
Just like I said before, diagonal spreads are a combination of vertical and horizontal spreads. This means that they try to profit from changes in both the underlying asset’s price and implied volatility/time. Diagonal spreads can be slightly to very directional strategies.
Recap – Options Spreads Explained
It is very important to understand what an options spread is and what different kinds of spreads exist. That’s why I want to recap some of the most important points of this article.
I created the following table to visually explain the different options spreads. Furthermore, this table actually reveals why the different spreads are called the way that they are (horizontal, vertical, diagonal).
Now you should know what different spreads exist. But you might ask yourself the question, which of these spreads is best.
There is no one right answer to this question. Not one spread is better than another. It really depends on the current market situation and on personal preferences. For instance, if you are bullish on a stock and want to take advantage of an upmove, a bull call vertical spread might be a good strategy. However, if you want to profit from a rise in implied volatility and don’t have a certain directional assumption, a horizontal/calendar spread would probably be a better choice…
I hope you understand what I am trying to say.
But generally speaking, vertical spreads are the simplest of the three. Horizontal and especially diagonal spreads are much more complex due to the different expiration dates of the different options. Therefore, I wouldn’t necessarily recommend trading (horizontal or) diagonal spreads if you aren’t completely familiar with them.
In the introduction, I mentioned that if you fully understand options spreads, you will understand all options strategies. But why do I think this?
The reason why I am saying this is that options spreads are the building blocks of almost all other options strategies. If you combine multiple options spreads, you can create almost any strategy. So instead of trying to understand how these dozens of different strategies work, it is much more efficient to learn how the building blocks of these strategies work.
Let me give you a few examples:
You probably realized that vertical spreads are relatively simple (compared to other options strategies). They are a twoleg strategy that consists of a long call and short call or a long put and short put.
But what happens if we combine multiple vertical spreads?
A new strategy is born! There are four different vertical spreads that can be combined to create a new strategy. I will now give you some concrete examples of what happens when you combine multiple vertical spreads.
Iron Condor
You may or may not know the option strategy iron condors. It is a very good and popular fourleg options strategy. Due to its four legs, it is usually labeled as an ‘advanced’ options strategy. But in reality, it isn’t anything else than a combination of two simple credit spreads.
I created the following image to explain this concept visually.
Hopefully, you can see how a combination of a bear call spread and a bull put spread create an iron condor.
Butterflies
Now let me give you another concrete example. Butterflies are another options strategy often referred to as complex and thus, only suitable for ‘advanced’ traders. But just like with iron condors, butterflies aren’t very complicated either. They are simply a combination of a bear call spread and a bull call spread.
Hopefully, these two examples make it clear how options spreads are the building blocks of most options strategies. These were just two of many examples where this is the case.
So in conclusion, options spreads can be thought of as Lego bricks. Just like Legos, options spreads can be combined in many different ways to create whatever your heart desires.
If you want to learn more about options strategies and when to use which strategies, you might want to check out my free strategy selection handbook.
My goal with this article was to introduce you to options spreads and thereby build a stable foundation for options trading strategies. It would be awesome of you to let me know if I achieved this goal in the comment section below!
Furthermore, if you have any questions, feedback or other comments, please tell me in the comment section.
10 Replies to “Options Spreads Explained – A Complete Guide”
Your explanation of the Option Spreads as building blocks to other strategies makes sense, but I am confused by the Iron Condor and Butterfly.
Does the Iron Condor and Butterfly make you money if the underlying asset price does not go over a certain amount or go over and then come back down before expiration?
That’s kind of what it looks like from looking at the graphs you included.
Thanks for your question. Iron condors and butterflies profit if the underlying asset’s price stays in a certain range. The size of this range depends on the strikes selected and the premium received/paid. I hope this helps with clarifying the confusion.
Otherwise, you could check out my article on Iron Condors and Butterflies.
Reading through this very comprehensive article on Option Spreads in Trading was so interesting. For someone new to this world of Trading it would need to be gone through a few times to fully understand all the terminology and nuances of trading. It is really complex for an ordinary person not versed in doing anything like this previously.
To my mind, if you are ready to Trade, you would need to be aware of the risks involved and not be afraid of losses. Only Trade with the amount you can afford, would be my way of thinking. Perhaps am too conservative.
It was very interesting to learn something new. Will take a look at it again at a later stage.
Thanks for the comment Jill. It is completely normal for people new to the world of trading to have trouble understanding everything. That’s actually also why I created a free trading terminology handbook in which you can look up all the seemingly complicated trading terms. So judging from your comment, you could definitely use my free trading glossary.
And no you are not too conservative! You should never risk more than you can afford to lose.
Hi Louis, I have completed your education classes and they are good, and I have learnt a lot. Best of all, I have learnt more from your free education than all the other programs I have paid for. Be leave me I have spent a lot of money on paid sites and it is not worth it. Selling short term options is my goal. However, I am have trouble comprehending receiving a credit when I sell an option. When I sell an option for a credit, I only receive the credit if it expires worthless Right. Thanks for your help
Hi Tom,
Thanks for the question. I hope I can clarify your confusion. When you sell an option to open a position, you receive a credit. So now you have a negative position open. To close this position, you could either buy back the sold option or wait until expiration. If you buy it back, you will give up some of the received credit. The amount of credit that you give back depends on the option’s price. If it has gone up, you might even have to pay more to close the position than you received when opening it.
If at expiration, the underlying’s price is at the right point, the option might expire worthless and only then, you could keep the entire credit that you collected when putting on the position.
Let me give you a concrete example:
You sell a call option with a strike price of $105 on XYZ which is trading at $100. You receive a credit of $1,50 (so $150). But now you have an open position which has to be closed for you to lock in the profit. As long as the position is open, the profits (or losses) are purely paper profits (or losses). They are only realized if you close the position which you can do by buying back the call option or by waiting until the expiration date.
Let’s say, you buy back the call option for $0,7 two weeks later. This would mean that you have a realized profit of $1,5 – $0,7 = $0,8 (or $80). So you can keep $80 of the collected credit.
If you instead wait until expiration and XYZ’s price is still below $105, you can keep the entire $150 of credit.
I really hope this helps. If you have any other followup questions, let me know.
Hi Louis,
In your reply to Tom looks like you did not mention that at expirations time if the stock price is above the strike price in a short call or below the strike price in short put, he would be forced to buy the stock at the strike price.
Thanks for the comment. Usually, when a trade such as a short call or short put is ITM shortly before expiration, I recommend closing the position for a loss. If you do this, you won’t have to buy or sell any shares at the strike price. I never recommend holding a losing short option position into expiration (unless you want to buy or sell stock at the strike price).
But you are right that if you would hold such a position into expiration, you would have to buy/sell stock at the strike price.
since a call spread would probably be assigned if the stock price goes above the strike price, it seems to me that it would be better to use a put spread when one expects the stock to go up and a call spread when one expects it to go down. Opposite of single options.
Hi and thanks for your comment,
I wouldn’t use assignment risk as a main factor when choosing which strategy to go for. Instead, I recommend looking at different market variables such as implied volatility, time till expiration, underlying asset, and price. Depending on the situation and your market assumption, a bull put spread can be better than a bull call spread and vice versa. The same goes for bear spreads. It depends on the situation.
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Bear Put Spread Explained
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Grasp The Basics Of Bear Put Options In 10 Minutes With Our Complete Guide
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Last Updated on August 14, 2020
A Bear Put Spread, also known as a put debit spread, is a bearish strategy involving two put option strike prices:
 Buy one atthemoney or outofthe money put
 Sell one put further away from the money than the put purchased
A trader would use a Bear Put Spread in the following hypothetical situation:
 A trader is very bearish on a particular stock trading at $50.
 The trader is either riskaverse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
 The trader expects the stock to move below $47.15 but not lower than $45.00 in the next 30 days.
Buy One Put – Sell One Put
Given those expectations, the trader selects the $47.50 put option strike price to buy which is trading for $0.44. For this example, the trader will buy only 1 option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract).
Also, the trader will sell the further outofthe money put strike price at $45.00. By selling this put, the trader will receive $9 ($0.09 x 100 shares/contract). The net effect of this transaction is that the trader has paid out $35 ($44 paid – $9 received).
Risk Defined & Profit Defined
When a Bear Put Spread is purchased, the trader instantly knows the maximum amount of money they can possibly lose and the maximum amount of money they can make. The max loss is always the premium paid to own the option contract minus the premium received from the offsetting put option sold; in this example, $35 ($44 – $9).
Whether the stock rises to $95 or $55 a share, the put option holder will only lose the amount they paid for the option spread ($35). This is the riskdefined benefit often discussed about as a reason to trade options. Similarly, the Bear Put Spread is profitdefined as well. The max the trader can make from this trade is $215. How this max profit is calculated is given in detail on the next page.
Bear Put Spread requires Accurate Predictions
The important part about selecting an option strategy and option strike prices, is the trader’s exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50/$45.00 Bear Put Spread would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $125 or $47.51, the spread strategy will expire worthless. Therefore, if a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.
Moreover, if the trader is exceptionally bearish and thinks the stock will move down to $40, then the trader should just buy a put rather than purchase a Bear Put Spread. In this example, the trader would not gain anymore profit once the stock moved below $45. This is explained on the next page.
Bear Put Spread Profit, Loss, & Breakeven
The following is the profit/loss graph at expiration for the Bear Put Spread in the example given on the previous page.
Breakeven
The breakeven point for the bear put spread is given next:
 Breakeven Stock Price = Purchased Put Option Strike Price – Net Premium Paid (Premium Paid – Premium Sold).
To illustrate, the trader purchased the $47.50 strike price put option for $0.44, but also sold the $45.00 strike price for $0.09, for a net premium paid of $0.35. The strike price paid was the $47.50. Therefore, $47.50 – $0.35 = $47.15. The trader will breakeven, excluding commissions/slippage, if the stock reaches $47.15 by expiration.
Max Profit
The breakeven point for the bear put spread is given next:
 Breakeven Stock Price = Purchased Put Option Strike Price – Net Premium Paid (Premium Paid – Premium Sold).
To illustrate, the trader purchased the $47.50 strike price put option for $0.44, but also sold the $45.00 strike price for $0.09, for a net premium paid of $0.35. The strike price paid was the $47.50. Therefore, $47.50 – $0.35 = $47.15. The trader will breakeven, excluding commissions/slippage, if the stock reaches $47.15 by expiration.
Partial Profit
Partial profit is calculated via the following, assuming the stock price is greater than the breakeven price:
 Bear Put Spread Partial Profit = Breakeven price – Stock price
For instance, the stock closed at $46.00 at expiration. Hence, the breakeven stock price ($47.15) minus the stock price at expiration ($46.00) would mean the trader profited $115 [($47.15 – $46.00) x 100 shares/contract]
Partial Loss
A partial loss occurs between the breakeven stock price and the upper purchased put strike price. The calculation is given next:
 Bear Put Spread Partial Loss = Stock price – Breakeven price
For example, a closing stock price at expiration of $47.40 is between the upper put strike price of $47.50 and the breakeven of $47.15 and is therefore going to be a partial loss. When calculated, the loss is $25 [($47.40 – $47.15) x 100 shares/contract].
Complete Loss
A complete loss occurs anywhere above the upper purchased put strike price ($47.50) which amounts to the entire premium paid of $35.
Bear Put Spread & Put Option Comparison
The Bear Put Spread is liked by many traders more than simply buying a put option for two main reasons:
 Reduces the capital spent/higher breakeven price.
 Is a strategy than incorporates reality.
Lower Cost, Lower Breakeven Price
Because a bear put spread involves the selling of an option, the money required for the strategy is less than buying a put option outright. Moreover, the breakeven price is raised when implementing a bear put spread. To illustrate the cash outlay and breakeven prices for a bear put spread and just a put option are given next:
 Bear Put Spread: cost $35; breakeven price $47.15
 Put Option: cost $44; breakeven price $47.06
On a percentage basis, the bear put spread is over 20% cheaper than the cost of just purchasing a put.
Realistic Expectations
The second advantage/disadvantage of a bear put spread is that this strategy considers the reality and probabilities of a potential move. Theoretically, the buying a put strategy has great profit potential. However, successful option traders generally focus on probabilities and take into consideration reality. A stock move from $50 to $45 is a 10% move. This has to occur in the time before expiration, in the example 30 days. In order for a rational options trader to buy just a put, the option trader has to expect a stock move lower that is greater than 10% within 30 days.
In conclusion, the bear put spread is a great alternative to simply buying a put outright: the bear put spread reduces the distance of the breakeven price and decreases the capital required to be bearish on a stock, it also is a strategy that takes into consideration realistic expectations.
Bear Put Spread
7.1 – Spreads versus naked positions
Over the last five chapters we’ve discussed various multi leg bullish strategies. These strategies ranged to suit an assortment of market outlook – from an outrightly bullish market outlook to moderately bullish market outlook. Reading through the last 5 chapters you must have realised that most professional options traders prefer initiating a spread strategy versus taking on naked option positions. No doubt, spreads tend to shrink the overall profitability, but at the same time spreads give you a greater visibility on risk. Professional traders value ‘risk visibility’ more than the profits. In simple words, it’s a much better deal to take on smaller profits as long as you know what would be your maximum loss under worst case scenarios.
Another interesting aspect of spreads is that invariably there is some sort of financing involved, wherein the purchase of an option is funded by the sale of another option. In fact, financing is one of the key aspects that differentiate a spread versus a normal naked directional position. Over the next few chapters we will discuss strategies which you can deploy when your outlook ranges from moderately bearish to out rightly bearish. The composition of these strategies is similar to the bullish strategies that we discussed earlier in the module.
The first bearish strategy we will look into is the Bear Put Spread, which as you may have guessed is the equivalent of the Bull Call Spread.
7.2 – Strategy notes
Similar to the Bull Call Spread, the Bear Put Spread is quite easy to implement. One would implement a bear put spread when the market outlook is moderately bearish, i.e you expect the market to go down in the near term while at the same time you don’t expect it to go down much. If I were to quantify ‘moderately bearish’, a 45% correction would be apt. By invoking a bear put spread one would make a modest gain if the markets correct (go down) as expected but on the other hand if the markets were to go up, the trader will end up with a limited loss.
A conservative trader (read as risk averse trader) would implement Bear Put Spread strategy by simultaneously –
 Buying an In the money Put option
 Selling an Out of the Money Put option
There is no compulsion that the Bear Put Spread has to be created with an ITM and OTM option. The Bear Put spread can be created employing any two put options. The choice of strike depends on the aggressiveness of the trade. However do note that both the options should belong to the same expiry and same underlying. To understand the implementation better, let’s take up an example and see how the strategy behaves under different scenarios.
As of today Nifty is at 7485, this would make 7600 PE In the money and 7400 PE Out of the money. The ‘Bear Put Spread’ would require one to sell 7400 PE, the premium received from the sale would partially finance the purchase of the 7600 PE. The premium paid (PP) for the 7600 PE is Rs.165, and the premium received (PR) for the 7400 PE is Rs.73/. The net debit for this transaction would be –
To understand how the payoff of the strategy works under different expiry circumstances, we need to consider different scenarios. Please do bear in mind the payoff is upon expiry, which means to say that the trader is expected to hold these positions till expiry.
Scenario 1 – Market expires at 7800 (above long put option i.e 7600)
This is a case where the market has gone up as opposed to the expectation that it would go down. At 7800 both the put option i.e 7600 and 7400 would not have any intrinsic value, hence they would expire worthless.
 The premium paid for 7600 PE i.e Rs.165 would go to 0, hence we retain nothing
 The premium received for 7400 PE i.e Rs.73 would be retained entirely
 Hence at 7800, we would lose Rs.165 on one hand but this would be partially offset by the premium received i.e Rs.73
 The overall loss would be 165 + 73 = 92
Do note the ‘ve’ sign associated with 165 indicates that this is a money outflow from the account, and the ‘+ve’ sign associated with 73 indicates that the money is received into the account.
Also, the net loss of 92 is equivalent to the net debit of the strategy.
Scenario 2 – Market expired at 7600 (at long put option)
In this scenario we assume the market expires at 7600, where we have purchased a Put option. But then, at 7600 both 7600 and 7400 PE would expire worthless (similar to scenario 1) resulting in a loss of 92.
Scenario 3 – Market expires at 7508 (breakeven)
7508 is half way through 7600 and 7400, and as you may have guessed I’ve picked 7508 specifically to showcase that the strategy neither makes money nor loses any money at this specific point.
 The 7600 PE would have an intrinsic value equivalent to Max [7600 7508, 0], which is 92.
 Since we have paid Rs.165 as premium for the 7600 PE, some of the premium paid would be recovered. That would be 165 – 92 = 73, which means to say the net loss on 7600 PE at this stage would be Rs.73 and not Rs.165
 The 7400 PE would expire worthless, hence we get to retain the entire premium of Rs.73
 So on hand we make 73 (7400 PE) and on the other we lose 73 (7600 PE) resulting in a no loss no profit situation
Hence, 7508 would be the breakeven point for this strategy.
Scenario 4 – Market expires at 7400 (at short put option)
This is an interesting level, do recall when we initiated the position the spot was at 7485, and now the market has gone down as expected. At this point both the options would have interesting outcomes.
 The 7600 PE would have an intrinsic value equivalent to Max [7600 7400, 0], which is 200
 We have paid a premium of Rs.165, which would be recovered from the intrinsic value of Rs.200, hence after compensating for the premium paid one would retain Rs.35/
 The 7400 PE would expire worthless, hence the entire premium of Rs.73 would be retained
 The net profit at this level would be 35+73 = 108
The net payoff from the strategy is in line with the overall expectation from the strategy i.e the trader gets to make a modest profit when the market goes down.
Scenario 5 – Market expires at 7200 (below the short put option)
This is again an interesting level as both the options would have an intrinsic value. Lets figure out how the numbers add up –
 The 7600 PE would have an intrinsic value equivalent to Max [7600 7200, 0], which is 400
 We have paid a premium of Rs.165, which would be recovered from the intrinsic value of Rs.400, hence after compensating for the premium paid one would retain Rs.235/
 The 7400 PE would have an intrinsic value equivalent to Max [7400 7200, 0], which is 200
 We received a premium of Rs.73, however we will have to let go of the premium and bear a loss over and above 73. This would be 200 73 = 127
 On one hand we make a profit of Rs.235 and on the other we lose 127, therefore the net payoff of the strategy would be 235 – 127 = 108.
Summarizing all the scenarios (I’ve put up the payoff values directly after considering the premiums)
Market Expiry  Long Put (7600)_IV  Short Put (7400)_IV  Net payoff 

7800  0  0  92 
7600  0  0  92 
7508  92  0  0 
7200  400  200  +108 
Do note, the net payoff from the strategy is in line with the overall expectation from the strategy i.e the trader gets to make a modest profit when the market goes down while at the same time the losses are capped in case the market goes up.
Have a look at the table below –
The table below shows the strategy payoff at different expiry levels. The losses are capped to 92 (when markets go up) and the profits are capped to 108 (when markets go down).
7.3 – Strategy critical levels
From the above discussed scenarios we can generalize a few things –
 Strategy makes a loss if the spot moves above the breakeven point, and makes a profit below the breakeven point
 Both the profits and loss are capped
 Spread is difference between the two strike prices.
 In this example spread would be 7600 – 7400 = 200
 Net Debit = Premium Paid – Premium Received
 165 – 73 = 92
 Breakeven = Higher strike – Net Debit
 7600 – 92 = 7508
 Max profit = Spread – Net Debit
 200 – 92 = 108
 Max Loss = Net Debit
 92
You can note all these critical points in the strategy payoff diagram –
7.4 – Quick note on Delta
This is something I missed talking about in the earlier chapters, but its better late than never :). Whenever you implement an options strategy always add up the deltas. I used the B&S calculator to calculate the deltas.
The delta of 7600 PE is 0.618
The delta of 7400 PE is – 0.342
The negative sign indicates that the put option premium will go down if the markets go up, and premium gains value if the markets go down. But do note, we have written the 7400 PE, hence the Delta would be
Now, since deltas are additive in nature we can add up the deltas to give the combined delta of the position. In this case it would be –
= – 0.276
This means the strategy has an overall delta of 0.276 and the ‘–ve’ indicates that the premiums will go up if the markets go down. Similarly you can add up the deltas of other strategies we’ve discussed earlier – Bull Call Spread, Call Ratio Back spread etc and you will realize they all have a positive delta indicating that the strategy is bullish.
When you have more than 2 option legs it gets really difficult to estimate the overall bias of the strategy (whether the strategy is bullish or bearish), in such cases you can quickly add up the deltas to know the bias. Further, if in case the deltas add to zero, then it means that the strategy is not really biased to any direction. Such strategies are called ‘Delta Neutral’. We will eventually discuss these strategies at a later point in this module.
Also, you may be interested to know that while the delta neutral strategies are immune to market’s directional move, they react to changes in volatility and time, hence these are also sometime called “Volatility based strategies”.
7.5 – Strike selection and effect of volatility
The strike selection for a bear put spread is very similar to the strike selection methodology of a bull call spread. I hope you are familiar with the ‘1 st half of the series’ and ‘2 nd half of the series’ methodology. If not I’d suggest you to kindly read through section 2.3.
Have a look at the graph below –
If we are in the first half of the series (ample time to expiry) and we expect the market to go down by about 4% from present levels, choose the following strikes to create the spread
Expect 4% move to happen within  Higher strike  Lower strike  Refer graph on 

5 days  Far OTM  Far OTM  Top left 
15 days  ATM  Slightly OTM  Top right 
25 days  ATM  OTM  Bottom left 
At expiry  ATM  OTM  Bottom right 
Now assuming we are in the 2 nd half of the series, selecting the following strikes to create the spread would make sense –
Expect 4% move to happen within  Higher strike  Lower strike  Refer graph on 

Same day (even specific)  OTM  OTM  Top left 
5 days  ITM/OTM  OTM  Top right 
10 days  ITM/OTM  OTM  Bottom left 
At expiry  ITM/OTM  OTM  Bottom right 
I hope you will find the above two tables useful while selecting the strikes for the bear put spread.
We will now shift our focus on the effect of volatility on the bear put spread. Have a look at the following image –
The graph above explains how the premium varies with respect to variation in volatility and time.
 The blue line suggests that the cost of the strategy does not vary much with the increase in volatility when there is ample time to expiry (30 days)
 The green line suggests that the cost of the strategy varies moderately with the increase in volatility when there is about 15 days to expiry
 The red line suggests that the cost of the strategy varies significantly with the increase in volatility when there is about 5 days to expiry
From these graphs it is clear that one should not really be worried about the changes in the volatility when there is ample time to expiry. However one should have a view on volatility between midway and expiry of the series. It is advisable to take the bear put spread only when the volatility is expected to increase, alternatively if you expect the volatility to decrease, its best to avoid the strategy.

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