I found the description of this strategy a bit confusing, it does look like a bear spread. and as I recall a bear spread max loss is the difference between premiums, so no downside “unlimited exposure”. so why in R11, when applying this same strategy for a holder of a concentrated single asset, it said that the investor become exposed to donwside risk if the price goes below the strike of the shorted put ??
As I understood it in L2, if the price goes below low strike price, the investor can still use the put of the higher strike and resell at a higher price than the one he would eventually forced to buy at it ( strike 2
PS: I’m referring to section 4.3.2 in the curriculum
I believe you are referring to a cashless collar. In this case, you have three legs: long a security, long a put, and short a call (not shorting a put). Bear spread is long and short a put with different exercise prices, without being long the actual security.
In a cashless collar, the long put helps to avoid downside risk, so that if the stock price were to drop below the strike price of the put (which is usually set slightly below current price, so if current price is $50, you may buy a put with strike price of $48). It doesn’t eliminate the downside risk because there is still possibility of a small loss between the strike price (48) and the current price (50). In addition, you would sell a call with a strike price that is slightly above the current price of the stock (lets say its 52). You will look for a strike price that allows you to collect a premium that is similar to the premium paid for the put. When you sell a call, you are giving up the upside. So if the price of the security is above 52, the call will be exercised and you will have to sell your long position at 52 even thought the security is trading even higher. if the price is between $48 and $52, both options expire worthless. You will have either a small loss (if price is between $48-50) or a small gain (if price is between $50-52). Finally, if the price falls below $48, you will exercise the long put and sell your long position at $48, even though the security is trading at a lower price.
Thanks a lot for replying. Actually, I was referring to the section right before the one about “cashless Collar”. section 4.3.2.1 " Purchase of puts". it you check the last 2 paragraphs, you’ll find where they explain strategy involving buying 2 puts. I think I got the logic behind it, since the investor holds the stock, so in a way the purchased put will hedge the stock position, but the short put will expose the investor to the downside risk.
sometimes I feel derivatives are easy and what most makes finance fun, but yet they have a charming confusing power
thanks for replying. I did mention that it’s Reading 11, under SS05 as specified in the thread where I posted. it’s a reading in individual portefolio management where they go through techniques to hedge the risks related to a concentrated position.
That is a bear put spread strategy. let’s put it that way:
Bear Put strategy = Short put (Strike X1 = $40) + Long Put (Strike X2 = $50)
Shorting the put will be used to offset the cost of buying the put cause you are collecting the premium
Long the put will be used cause you have a view that the underlying will decline
So the take away from this strategy:
You are protected anywhere between X1 & X2
you will lose this protection if underlying price is below X1 (Hence the downside risk) - cause you will have to pay the put buyer X1 = $40 while you would have to buy the underlying at the market price of say $38
Shorting the put will partially offset the cost you paid to long the put
Because we have to go to the market to buy the same asset we already sold for X2 (50) at X1 (40) in order to settle the Short Put position instead of buying it in the market at the current price of 38.
So is the client exposure not suppose to be the difference between 38 and 40?, why the whole of 38?
Clear… Another question… Since we paid the Put buyer 40 as against the current market price of 38, shouldn’t the whole exposure be the whole 38 (current value of the asset) and the additional $2 premium paid to the Put buyer by paying him $40.
Since the initial Long position is between 50 and 40, claiming that his exposure is limited to the current value of $38 does not complete the equation, where does the remaining $2 disappear to?
