Explanation:
In a bear spread strategy, an investor sells a European put option with a specific strike price and simultaneously buys a European put option with a higher strike price. This strategy is designed to profit from a decrease in the price of the underlying asset. The sold put option (with a lower strike price) will generate income, which helps to offset the cost of the purchased put option (with a higher strike price). If the price of the underlying asset falls below the strike price of the purchased put option, the investor can exercise this option, selling the asset at the higher strike price. However, if the price of the underlying asset is above the strike price of the sold put option at expiration, this option will be worthless, and the investor will only lose the net premium paid for the spread. Therefore, the maximum loss for the investor is limited to the net premium paid for the spread, while the maximum profit is the difference between the two strike prices minus the net premium paid. This strategy is called a bear spread because it profits when the price of the underlying asset falls, similar to how a bear market is characterized by falling prices.
Choice A is incorrect. This choice suggests buying a European put option with a specific strike price and selling another with a higher strike price. However, this would result in a bull spread strategy, not a bear spread. In the bear spread strategy, the investor expects the price of the underlying asset to fall and hence would sell an option at a lower strike price while buying another at a higher strike price.
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Q.770 Nancy Smith is an independent individual investor. She has 5 years of experience trading equities, bonds, and options. Smith has recently learned about spread strategies in options that could be implemented to earn protected profits. She is particularly interested in implementing the bear spread strategy. Keeping in view Smith's intended spread strategy, determine how she can implement the bear spread strategy.
A
She can implement the bear spread strategy by buying a European put option with a specific strike price and simultaneously selling a European put option with a higher strike price.
B
She can implement the bear spread strategy by selling a European put option with a specific strike price and simultaneously buying a European put option with a higher strike price.
C
She can implement the bear spread strategy by buying a European put option with a specific strike price and simultaneously buying a European call option with a lower strike price.
D
She can implement the bear spread strategy by selling a European put option with a specific strike price and simultaneously buying a European put option with a lower strike price.