Traders and investors have a number of different tools at their disposal to determine a position (when to buy or sell a commodity) depending on their market view. Two of these methods are the bull spread and the bear spread. The bull spread is used to reduce the risk potential for a profit; a bear spread is used to try to reduce losses and maximize profit when prices are declining. There are two types of options used in bull and bear spreads—a call option, or the option to buy; and a put option, or an option to sell. The put and call options for each of the different spreads have different effects on the trader and their capital. Traders can trade the physical commodity or derivatives of them. The following explanations assume derivatives are used in the trades and options described.
Bull Spread
The bull spread is determined by using strike prices between the high and low prices a trader wants to trade at. A strike price is an option a trader purchases, with no requirement to execute, which guarantees them the ability to purchase or sell at the price they purchased. A bull trader purchases an option to buy a commodity—referred to as going long—with a low strike price, and another option to borrow and sell the same commodity—referred to as going short—with a high strike price. The difference between the buy and sell strike prices is the spread; this technique reduces the risk of selling too low or buying too high while maximizing profit. The bull put and call spreads are referred to as vertical spreads because the positions of the strike prices on a graph are vertically separated.
Bull Put Spread
A bull put spread—or a short put spread—is the difference between two put options (options to sell). The trader purchases a short put option with a high strike price and a long put option with a low strike price, in an attempt to garner a premium from the sale.
Bull Call Spread
Also called a long call spread, the bull call spread is similar to the put spread, except it uses calls (purchase options). The trader purchases a call option on a commodity with a strike price at or below the price of the stock, and then sells a call option with a higher strike price. Profit isn’t limited using this technique, so long as the commodity price rises above the strike price and the premium paid for the option. If the price lowers below the short strike price, the loss is limited to the premium paid for the call option.
Bear Spread
The bear spread is used by a bearish trader. This is similar in nature to the bull spread but uses a strategy for the belief that prices will continue to drop. The bear spread is built by selling a call option with a strike price, and then buying a call option at a higher strike price.
Bear Put Spread
A bear put spread—sometimes called a long put spread—is built by purchasing a put option and simultaneously selling the same quantity of another put option, with the same maturity, that is further below the current market price than the one purchased. The spread is the difference in the strike prices minus the premium paid for the bear put spread.
Bear Call Spreads
To limit risk, a short call spread will express a bearish view. In this case, the profit is limited (the price can only go to zero) so long as the price moves above the strike price of the option and the premium paid. If the price moves higher, the loss is limited to the premium paid for the put option.
Spread Types
Each of the types of spread is further classified into either debit or credit spreads. The bull call spread and the bear put spread are debit spreads, because premiums are paid. Bull put spreads and the bear call spreads are credit spreads, in that they collect premiums (money paid for the options purchase).
Backwardation
Commodities are traded in terms, or a period of time with a delivery date. Deferred prices refer to the later months in a term, while nearby refers to the months in a term that are closer to the purchase date. Backwardation is a market condition whereby deferred prices are lower than nearby prices. Buying the nearby futures contract and simultaneously selling the deferred futures contract in the same commodity is a bull spread in futures. This spread makes money if the backwardation widens or nearby prices increase more than deferred prices. It tends to happen when a supply shortage worsens.
Contango
A bear spread on futures involves selling the nearby futures contract and simultaneously buying the deferred contract. Contango is a market condition whereby deferred prices are higher than nearby prices. The bear spread in futures makes money if the contango widens or deferred prices move higher than nearby prices. It tends to happen when a market glut increases. Both of these futures spreads are intra-commodity spreads, time or calendar spreads, and expresses a market view of supply and demand.
The Bottom Line
In the world of commodities, the futures market offers many ways for market participants to express their bullish or bearish views on price or supply and demand. Bull and bear spreads are complicated trading mechanisms and are generally used by more sophisticated and clued-in traders. The different types of stances traders take can dictate the actions they take on their derivatives and commodity trades. Bear and bull spreads help investors reduce the risk of a loss of capital while providing maximum returns in both bear and bull markets—as long as their assumptions of price trends are correct.
