Bear Put Spread Explained



The bear put spread strategy is the opposite of the bull put spread strategy and should be deployed when you think the price of the underlying asset will go down moderately in the short term.

Bear put spreads are implemented by buying a higher strike in-the-money put option and selling a lower strike out-of-the-money put option of the same underlying asset with the same expiration date.

Here’s how it’s constructed:

Buy 1 In The Money (ITM) Put – Sell 1 Out of The Money (OTM) Put

By shorting the out-of-the-money put, you reduce the cost of establishing the bearish position but forgo the chance of making a large profit in the event that the price of the underlying asset falls.

Maximum Potential Profit

To reach the maximum possible profit, the stock price needs to close below the strike price of the out-of-the-money put upon expiration. This result’s in both options expiring in the money but the higher strike put that was purchased will have higher intrinsic value than the lower strike put that was sold. Therefore the maximum profit is equal to the difference in strike price minus the debit taken when the position was entered.

You can calculate the maximum potential profit by using the formula below:

  • Max Profit = Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Put

Maximum Potential Loss

If the price of the underlying asset rises above the in-the-money put option strike price at expiration. Then you’ll suffer the maximum loss possible, which is equal to the debit taken when placing the trade.

You can calculate the maximum potential loss by using the formula below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven

The underlying price at which breakeven is achieved can be calculated using the formula below.

  • Breakeven Point = Strike Price of Long Put – Net Premium Paid

Bear Put Spread Example

Let’s say you think IBM stock, currently trading at $38, is overvalued and heading for a fall. So you decide to open a bear put spread position by simultaneously buying a JUN 40 put for $300 and selling a JUN 35 put for $100, which results in a net debit of $200.

The price of IBM stock subsequently drops to $34. Both puts will now expire in-the-money, with the JUN 40 call having $600 in intrinsic value and the JUN 35 call having $100 in intrinsic value. The spread will then have a net value of $5 (the difference in strike price). Deducting the debit taken when you placed the trade, your net profit is $300.

If on the other hand the stock rallied to $42, both of the options will expire worthless, and you’ll lose the entire debit of $200 taken to enter the trade. This is the maximum possible loss you could have incurred.

Commissions

To make the above example easier to understand we omitted to include any trade commissions. In the real world you’ll have to pay commissions to your broker for every trade you make. For smaller traders these commissions are unlikely to break the bank, they usually range between $10 and $20.

Once you gain a little more experience and start to put together more complex options chains that involve three or more individual contracts, these commissions can become quite excessive. Fortunately there are brokers that specialize in this type of trading; a good example would be OptionsHouse where commissions start as low as $0.15 per contract ($8.95 per trade).

Conclusion

The bear put spread is an easy strategy to get your head around. Since it only involves two contracts and has a limited downside it’s the perfect strategy for a beginner to try.

Always remember to try it out first in a virtual environment before you risk any real capital. That way you’ll know your comfortable with how it works and how it’s constructed, not to mention whether or not it makes a profit for you.

 




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