Bear Put Spread

[Igor 10]

Traders who implement a bear put spread are betting that the market price of an option's underlying asset will fall. The technique involves buying and selling put options for the same underlying asset. The profit potential and risk involved when using this strategy are both limited. The bear put spread strategy limits an investor's profits to the amounts received when settling the put options, and the maximum loss only equals what he or she pays to enter the market.

 

Moneyness Review for Puts

Out-of-The Money (OTM) = Strike price (less than) Market Price

In-The-Money (ITM) = Strike price (more than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

 

How to Carry Out a Bear Put Spread

 

 

Disney stock is worth $38 (market price) in June.

1) Trader sells a put option: DISJul35($1)

- 100 shares of Disney stock

- Strike Price $35, out-of-the-money (OTM), expiring in 30 days

- Premium Cost of $1

2) Trader buys a put option: DISJul40($3)

- 100 shares of Disney stock

- Strike Price $40, in-the-money (ITM), expiring in 30 days

- Premium Cost of $3

3) Trader pays a total of $200 to enter the market [$300 (paid to purchase put) - $100 (received from put sale)]

 

Total cost to enter the market: $200

 

Result one: Disney falls to $34

a) The put option sold expires ITM. The investor who bought the trader's put option exercises his or her right to sell 100 shares at $35. The trader pays $3500 to the buyer, and receives 100 Disney shares.

b) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer.

c) The trader makes a total profit of $300 after subtracting the costs to enter the market. [$300 = $4000 (received for 100 shares) - $3500 (paid for 100 shares) - $200 (cost to enter market)]

 

Result two: Disney rises to $42

a) The put option bought expires worthless (OTM)

b) The put option sold expires worthless (OTM)

c) Trader loses a total of $200 after adding the amount paid to enter the market.

 

Result three: Disney falls to $38 (Breakeven)

a) The put option sold expires worthless (OTM)

b) The trader buys 100 Disney shares in the open market for $3800.

c) The put option bought is ITM. The trader exercises his or her right to sell 100 shares at $40 to the investor who wrote the put option. The trader sells his or her Disney 100 shares and receives $4000 from the writer.

d) The trader breaks even, making a total profit of $0 after subtracting the costs to enter the market. [$0 = $4000 (received for 100 shares) - $3800 (paid for 100 shares) - $200 (cost to enter market)]

 

Advantages and Disadvantages in Carrying Out a Bear Put Spread:

 

Pluses: The upside to this type of strategy is that the investor knows exactly how much he or she will win or lose before carrying out the bear put spread strategy. The investor also knows the strategy's breakeven point, which is the strike price of the put option purchased subtracted from the cost to enter the market.

 

Minuses: The downside in using bear put spread strategy is that the method limits an investor's profits. If the market value of the underlying stock falls significantly, the trader will only gain the price difference between the two put option's strike prices.