Bear call spread
To build a bear call spread strategy, we have to buy one call (OTM) and sell one call (ITM).
It’s important to precise that underlying assets are the same and options mature at the same date.The caracteristics of these two options are strictly equal except for the strike, this difference allows traders to build the hedging of the position.
Indeed, long call will have a superior strike than short call. The objectif of traders is to speculate on a downward trend of the underlying asset while avoiding excessive losses. Buying a call cap losses if the underlying asset is not going down.
Bear call spread pay off :
If the two options are OTM then we will obtain the maximum pay off which is equal to the credit prime received from the short call minus the prime paid to buy a call.
But, if the short option is ITM and the long option is OTM then the loss while be K-S (x number of shares). Finally, if both options are ITM we will observe the maximum loss, this is the formula to estimate it :
Spread between both strikes*number of actions – prime from short call + prime paid for long call + fees
Bull put spread
Bull put spread is the complete opposite of a bear call spread. Indeed, to build it we have to buy (OTM) and sell (ITM) a put, which have respectively two strikes (K1) and (K2).
We implement this strategy when we are waiting for a slight increase of the underlying asset.
As for the bear call spread, pay off is capped, the maximum is equal to the credit prime received from the short put, and the minimum is the spread between both strikes minus prime received from the short put plus prime paid for the long put.
Bull put spread pay off
(Bull Put Spread – Overview, How It Works, Example (corporatefinanceinstitute.com)
Now, if we put together both strategies, we will obtain a third one named Iron condor. The iron condor can be a long or short strategie, if traders decide to be long then they are waiting for low volatility and more he expects low volatility, the closer strikes are to the spot (circled strike prices on the below graph). If traders are short, then they are waiting for high volatility.
Iron condor pay-off
In the case of traders are long, it’s better that underlying asset price stay between these two strikes, because they will receive credit primes from the two previous strategies explained before (Maximum PnL).
For a short strategy, the pay-off is the complete opposite
To conclude, if we want to have an higher pay-off, we have to build a strategy more agressive by tightening both strikes (short call and short put) around the spot price of the underlying for a long position. But building a strategy in that way include more risk because the volatility range is closer. In the case of a short position both strikes must to be further away from the spot price. We can define it by « openning the volatility range » for a short position or « closing the volatility range » for a long position.