Options Trading Strategy: Bear Put Spread - AxisDirect
Feb 16, 2018 | Source: Investopedia
Options Trading Strategy – Bear Put Spread
A bear put spread, also known as a bear put debit spread, is a type of options strategy used when an option trader expects a decline in the price of the underlying asset. A bear put spread is achieved by purchasing put options at a specific strike price while also selling the same number of puts with the same expiration date at a lower strike price. The maximum profit using this strategy is equal to the difference between the two strike prices, minus the net cost of the options.
BREAKING DOWN 'Bear Put Spread'
For example, let's assume that a stock is trading at ₹30. An option trader can use a bear put spread by purchasing one put option contract with a strike price of ₹35 for a cost of ₹475 (₹4.75 * 100 shares/contract) and selling one put option contract with a strike price of ₹30 for ₹175 (₹1.75 * 100 shares/contract). In this case, the investor will need to pay a total of ₹300 to set up this strategy (₹475 - ₹175). If the price of the underlying asset closes below ₹30 upon expiration, then the investor will realize a total profit of ₹200 ((₹35 - ₹30 * 100 shares/contract) - (₹475 - ₹175)) or (₹500 - ₹300).
Advantages of a bear put spread
The main advantage of a bear put spread is that the net risk of the trade is reduced. Selling the put option with the lower strike price helps offset the cost of purchasing the put option with the higher strike price. Therefore, the net outlay of capital is lower than buying a single put outright. And it is carries far less risk than shorting the stock or security since risk is limited to the net cost of the bear put spread. Selling a stock short theoretically has unlimited risk if the stock moves higher.
If the trader believes the underlying stock or security will fall by a limited amount between trade date and expiration date then a bear put spread could be an ideal play. However, if the underlying stock or security falls by a greater amount then the trader gives up the ability to claim that additional profit. It is a tradeoff between risk and potential reward that is appealing to many traders.
With the example above, the profit from the bear put spread maxes out if the underlying security closes at ₹30—the lower strike price—at expiration. Closes below ₹30 will not result in any additional profit. Closes between the two strike prices will result in reduced profit while closes above the higher strike—₹35—will result in a loss of the entire amount spent to buy the spread.