Let’s turn now to the 2 bearish spreads, but this time using equity options. SockStock is trading at $114.50 and we are trying to decide between the 115-105 bear put spread and the 115-105 bear call spread. The table below summarizes the risk and profit potential of these 2 spreads.
Here the 2 comparable spreads (meaning those with the same expiration and same strikes) have exactly the same risk-reward profiles. There is the question of initial credit versus initial debit, but since we are dealing with equity options, there is also the issue of potential early assignment and/or early exercise.
First, let’s look at the result of early assignment/exercise for the debit spread, the bear put spread. This position is long the 115 put and short the 105 put. There is no reason to exercise the long 115 put early, unless the short 105 put is assigned. Under what circumstances would this happen, and what would be the result?
The short 105 put would only be assigned if the price of SockStock fell below $105. The result of the assignment is the obligation to purchase shares at 105 but at this point one can simply exercise the long 115 put, sell the shares at 115 and realize the spread’s maximum value, $10. This scenario implies that the stock has declined (the reason one establishes a bear spread is a forecast of lower prices), the trade is profitable and in fact the position exited at its maximum potential value. Everything has gone right.