The bear put spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term.
Bear put spreads can be implemented by buying a higher striking in-the-money put option and selling a lower striking out-of-the-money put option of the same underlying security with the same expiration date.
|Bear Put Spread Construction|
|Buy 1 ITM Put|
Sell 1 OTM Put
By shorting the out-of-the-money put, the options trader reduces the cost of establishing the bearish position but forgoes the chance of making a large profit in the event that the underlying asset price plummets. The bear put spread options strategy is also know as the bear put debit spread as a debit is taken upon entering the trade.
To reach maximum profit, the stock price need to close below the strike price of the out-of-the-money puts on the expiration date. Both options expire in the money but the higher strike put that was purchased will have higher intrinsic value than the lower strike put that was sold. Thus, maximum profit for the bear put spread option strategy is equal to the difference in strike price minus the debit taken when the position was entered.
The formula for calculating maximum profit is given below:
If the stock price rise above the in-the-money put option strike price at the expiration date, then the bear put spread strategy suffers a maximum loss equal to the debit taken when putting on the trade.
The formula for calculating maximum loss is given below:
The underlier price at which break-even is achieved for the bear put spread position can be calculated using the following formula.
Suppose XYZ stock is trading at $38 in June. An options trader bearish on XYZ decides to enter a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for $100 at the same time, resulting in a net debit of $200 for entering this position.
The price of XYZ stock subsequently drops to $34 at expiration. Both puts expire in-the-money with the JUL 40 call bought having $600 in intrinsic value and the JUL 35 call sold having $100 in intrinsic value. The spread would then have a net value of $5 (the difference in strike price). Deducting the debit taken when he placed the trade, his net profit is $300. This is also his maximum possible profit.
If the stock had rallied to $42 instead, both options expire worthless, and the options trader loses the entire debit of $200 taken to enter the trade. This is also the maximum possible loss.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The bear put spread is a debit spread as the difference between the sale and purchase of the two options results in a net debit. For a bearish spread position that is entered with a net credit, see bear call spread.
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