Bear Put Ladder Spread

Reasons for Using

You would use the bear put ladder spread if your expectation was that a security would drop in price, but that the drop would only be moderate. It's generally used as an alternative to the bear put spread when the motivation is to reduce the upfront cost.

It can be structured to result in a low net debit, or even a net credit, at the time of being applied. This strategy can lead to significant losses should the security fall in price dramatically, so it shouldn't be used if you believe there is much chance of this happening.

How to Use the Bear Put Ladder Spread

The bear put ladder spread is one of the more complicated strategies, as there are a total of three transactions required. You need to buy put options, ostensibly, so that you will make a profit if the underlying security falls in price as expected. Additionally, you need to write an equal number of puts options at a lower strike and write an equal amount of puts options again with an even lower strike.

You write options essentially to offset the cost of the ones purchased. Generally speaking you would look to make the three transactions simultaneously, but you can leg into the spread if you prefer.

You will need to decide exactly which strikes you use when establishing the spread. A good rule of thumb is to buy puts that are at the money, or close to it, and write one batch of puts with a strike equivalent to roughly where you predict what the price of the underlying security will fall to. The next batch of puts written should then be written with the next lowest strike.

The lower the strikes of the options that you write, the less money you will receive at the time of writing them. However, lower strikes will give you a greater potential profit so its something of a trade-off. All the contracts should have the same expiry date.

We have put together an example of how you might use this spread. First, we will assume that Company X stock is trading at $50, and your forecast is that the stock will fall to around $45, but no lower. You would place the following orders with your broker.

• Buy to open at the money puts (based on Company X stock). Strike of $50.
• Sell to open out of the money puts on the same security. Strike of $45.
• Sell to open more out of the money puts on the same security. Strike of $44.

We shall now examine the money involved in these transactions. Please note that we haven't used exact market data for this example and the prices are hypothetical. No commission costs have been included.

• Puts with the $50 strike are trading at $2. You buy 1 contract, containing 100 options, for a total cost of $200.
• Puts with the $45 strike are trading at $.40. You write 1 contract, containing 100 options, for a credit of $40.
• Puts with the $44 strike price are trading at $.30. You write 1 contract, containing 100 options, for a further credit of $30.

The $200 spent on is partially offset by the $70 credit received for writing contracts. The net result is you have created a debit spread, and the total cost is $130. We can now look at the potential profits, and losses, this strategy could return.

Potential for Profit & Loss

The potential profit is limited, and the maximum profit is made when the underlying security (in this case Company X stock) falls in price to somewhere between the strikes of the puts written (in this case between $44 and $45).

If the security falls lower than the lowest strike ($44), then the profits will start to diminish and the position can even move into a loss if the price goes low enough. If the security doesn't fall in price at all, or goes up in price, then the initial investment ($130) will be lost. We have provided some examples of what would happen in a few different scenarios.

Company X stock remains at $50 by expiry

• The options bought will be at the money, and worthless, while the ones written will be out of the money and also worthless. With no further returns or liability, the loss is the amount of the initial investment - $130.

Company X stock falls to $47 by expiry

• The options bought will be in the money and worth roughly $3 each for a total of $300.
• The options written will all be out of the money and therefore worthless.
• You profit will be the $300 less your initial $130 investment. You will have made a total profit of $170.

Company X stock falls to $45 by expiry

• The options bought will be in the money, and worth roughly $5 each for a total of $500.
• The options written will all be out of the money and therefore worthless.
• You profit will be the $500, less your initial $130 investment for a total of $370.
• This is the maximum profit you can make, and it's made when Company X stock price is anywhere between $44 and $45.

Company X stock falls to $40 by expiry

• The options bought will be in the money and worth around $10 each for a total of $1,000.
• The options written (strike $45) will be in the money and worth around $5 each for a total liability of $500.
• The options written (strike $44) will be in the money and worth around $4 each for a total liability of $400.
• The value of the options owned ($1,000), minus the liabilities ($900) and the initial investment ($130), gives you a total loss of $30.
• The further the price of Company X stock fell, the more you would lose. Remember, though, you can close the position early at any time by selling the options owned and buying back the ones written.

Benefits & Drawbacks

The biggest benefit of the bear put ladder spread is the reduced costs of taking a position that can profit from a security going down in price. The strategy also provides a lot of flexibility, enabling you to enter a position that best suits. By simply adjusting the strikes accordingly, you can choose to reduce the potential losses or increase the potential profits. This is very useful when it comes to planning your trades and practicing good risk management.

The main drawback is the potential losses if the price of the underlying security should fall more than expected. Although you can close the position early if need be, this may be too late if the price drops very quickly. This strategy also comes with a margin requirement, meaning that you have to tie up additional capital in your account.

Although the margin requirement can be reduced if you write options with a lower strike price, this will reduce the amount of credit you receive and therefore increase your upfront costs.

Summary

If you are very confident that an underlying security will fall, but not fall below a specific price, then the bear put ladder spread is well worth considering. The potential profits can be reasonably high in relation to the upfront costs, which is obviously appealing.

However, there is the risk of substantial losses and this somewhat complex strategy isn't recommended for beginner traders.