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| Suitable market view: | Market to drop 3-10 percent. | | Maximum profit: | The difference in strike price minus the net cost to establish the position. | | Maximum loss: | Net cost to establish the position. | | Realization of profit or loss: | The position is usually closed at, or just before, the expiry day. | | Margin requirements: | The position implies no, or very limited margin requirements. |
Market view
Establishing a negative price spread, sometimes called baisse spread, is a suitable strategy when you believe in a moderate decline in a stock or an index until a certain date, preferably the option’s expiry date.
Construction
The most common way to establish the strategy is to buy put options with a higher strike price and at the same time write equally many put options at a lower strike price. However, the strategy can also be established with call options. In this case you write call options at a lower strike price and buy equally many call options at a higher strike price. In both alternatives the options should have the same expiry month. The difference between the alternatives is that if you establish the position with put options you have a capital expenditure; while in the call option case have a capital income. On the other hand will a negative price spread with call options imply considerably larger margin requirements?
Example:
It is the 30th of November and the ABC index level is 800. The stock market has gone up substantially since mid October with the support from falling market interest rates and a strong US stock market. However, your opinion is that the market has gone up too heavily and find it likely that the market will adjust downwards between 5 and 10 percent, corresponding to a index value of 760-720 until the expiry day on the forth Friday of December.
Since December is historically a strong month for the stock market and you only believe in a relatively moderate decline, you find it too expensive just to buy put options. To limit your maximum risk of loss you instead establish a negative price spread by buying 10 put options contracts at strike price 800 at a cost of 2,000 crowns per contract. At the same time you write an equal amount of put option contracts at a strike price of 760 and receive an income of 800 crowns per contract. This gives you a net cost of 10 x (2,000 – 800) = 12,000 crowns.
Results on the expiration day
The outcome from different index levels on the expiry day is shown in the table below:
| Index value on the expiration day | Value 10 purchased Dec 800 put options | Value 10 written Dec 760 put options | Net premium paid | Total result | | 810 | 0 | 0 | -12,000 | -12,000 | | 800 | 0 | 0 | -12,000 | -12,000 | | 790 | 10,000 | 0 | -12,000 | -2.000 | | 788 | 12,000 | 0 | -12,000 | 0 | | 780 | 20,000 | 0 | -12,000 | 8,000 | | 770 | 30,000 | 0 | -12,000 | 18,000 | | 760 | 40,000 | 0 | -12,000 | 28,000 | | 750 | 50,000 | -10,000 | -12,000 | 28,000 | | 740 | 60,000 | -20,000 | -12,000 | 28,000 |
Winn, loss and break-even
The maximum profit from the above position amounts to 28,000 crowns. It arises if the index value closes at a maximum of 760 on the expiry day, corresponding to a decline of at least five percent. The maximum profit is calculated as the difference between the two strike prices minus the net premium multiplied by 1,000, i.e. (800 – 760 – 12) x 1,000 = 28,000 crowns. Since you paid 12,000 crowns for the price spread that corresponds to a return of 233 percent on invested capital during the period. The maximum loss is the invested capital of 12,000 crowns and will arise if the index value on the expiry day closes above 800.
Thanks to the strategy’s low net cost you reach the position’s break-even already at an index value of 788, corresponding to a decline of 1.5 percent from index value 800. If you instead had bought only put options with a strike price of 800 for 2,000 crowns per contract, your break-even would have first been at 780.
Realization of profit
The negative price spread strategy is an expiry day strategy, since it, despite a correct market opinion, is very rarely possible to realize the maximum profit until the expiry day. This is due to the fact that when the market declines, both your purchased and written options will gain value, if not to a varying degree, and it is first at the expiry day that the difference between them will be 4,000 crowns per contract. The reason behind this is that with a correct market opinion your written options will always be closer to pari than your purchased option, and therefore they will always contain more time value. It is first on the expiry day that the time value in both options is zero. If you choose a negative price spread it is however usually easier, with a correct market opinion, to realize the majority of the profit before expiration, compared to if you had chosen to set up a ratio spread or a ladder.
Follow-up and protection
The advantage with establishing a negative price spread is that you, contrary to a ratio spread or a ladder, never risk losing more than the net-premium paid. In addition, the probability is high that you, with an incorrect market opinion, risk losing considerably less than that.
If you notice that the market, contrary to your opinion, starts to move upwards or lies still you have several different possible ways to act depending on your new market opinion and your risk aversion. For example:
- If you believe that the market will continue to rise, or at least not drop below 760, you can sell your purchased options with a strike price of 800 and let your options with a strike price of 760 be written naked. Do not forget that the risk with naked written options is only limited by the fact that a stock index can never drop below zero.
- If you consider the above alternative to be too risky, you close the whole position as soon as you notice that the market did not behave the way you expected.
- If, despite the rise, still believe in declining levels, but do not believe anymore that the index level will fall as much as earlier, you can establish a ratio spread instead. You do that by keeping your price spread and in addition write another 10 put option contracts with a strike price of 760. Then you will have a position consisting of 10 purchased put options with a strike price of 800 and 20 written put options with a strike price of 760.
Advantages with a negative price spread
- High return on invested capital
- The maximum loss is limited to the net premium
- Good possibilities to avoid a large loss having had an incorrect market opinion
Drawbacks with a negative price spread
- Limited profit potential
- Hard to realize the maximum profit before the expiry day
Choice of strike prices
Which strike prices to choose depends on how much percent you think that an index or a single stock will drop, and how much capital you are willing to risk. As usual, the more capital you are willing to risk, the higher the probability is that you will earn money from the position. On the other hand you will have a lower return on invested capital, in percentage terms.
As an example we can compare the above position with an example where you establish a negative price spread by buying 10 put option contracts with strike price 780 for 15,000 and at the same time write an equal amount of put options with strike price 730 for 5,000 crowns. In this case the maximum loss is (15,000 – 5,000) = 10,000 crowns, i.e. lower than our original example measured in crowns. In addition, the maximum profit has risen to 40,000 crowns, corresponding to 400 percent on invested capital. On the other hand the probability is now lower that you will make any profit at all, since a decline down to an index value of 770 is needed, corresponding to 3.7 percent, for you to reach break-even. At the same time, a decline of an entire 8.7 percent, down to an index value of 730, is needed for you to reach your maximum profit.
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