The Bear Put Spread Strategy

Why Use It

The primary use of the bear put spread is to try and profit from the price of a security going down. You should use this strategy when you expect that a security will go down in price significantly but not by a huge amount. The strategy is really a method of reducing the capital requirements of buying puts, and minimizing the negative effect that time decay has on the price of any options that you own.

How to Apply the Bear Put Spread

This is one of the simpler strategies, and it involves making two transactions. These two transactions should be made simultaneously with your broker, although you can consider legging into the position if you are confident about getting your timing right.

The two transactions you need to make are buying at the money puts, and writing an equal number of out of the money puts i.e. contracts with a lower strike. The contracts should be based on the same relevant underlying security and have the same expiration date. This will create a debit spread, meaning an upfront cost, because the options you buy will be more expensive than the ones you write.

The main reason for writing the contracts is basically to reduce the cost of buying the contracts that you hope to profit from. It's up to you to decide which strike to use when writing the contracts, but a good general rule is to use a strike that is approximately the same as what you expect the price of the underlying security to be at the time of expiration.

The lower the strike you use, the greater your potential profits will be, but the less credit you will receive to offset the cost of the initial investment.

Profit & Loss Potential

This strategy aims to make a profit through the underlying security decreasing in price. However, you can also profit from the effects of time decay, because the options you have written will fall in value over time providing the underlying security doesn't drop so far in price that they move into the money.

The maximum profit is made when the price of the underlying security falls to exactly the strike used in the contracts written. When this happens you will profit from the puts you own increasing in value, but will have no liabilities on the contracts you have written, because they will expire worthless. If the price of the underlying security falls even further you will start to lose money on the contracts written. However, the puts you own will also continue to increase in value so this has no net effect.

You'll lose money if the underlying security increases in price, does not move at all, or does not go down enough to make a profit on the puts you own. The maximum you can lose is your initial investment: which will only happen if the puts you own expire worthless (along with the ones you have written).

Advantages

The main advantage offered by this strategy is the reduction in cost of putting on a long put position through also putting on a short put position. This does have the effect of limiting your potential profits, but you can influence how much you can make from the spread by selecting the strike of the written contracts as you see fit.

Because the spread reduces the upfront costs, it means you can potentially make a big return on your investment: with the added benefit of decreasing the amount you can lose. You know precisely how much you can possibly lose at the point of putting the spread on, which can help with planning trades. The simplicity of the strategy is also a notable advantage.

Disadvantages

There isn't a huge amount in the way of disadvantages associated with this strategy. Because there are two transactions instead of one (compared to simply buying puts), you will pay more in commission, but the overall reduced upfront cost compensates for this. The fact that your profits are limited even if the underlying security falls a lot further than expected is a negative, but this is why you would use this strategy when you are only expecting a security to drop in price by a certain amount.

Example

Below we have provided a rough example of establishing a bear put spread and what the potential outcomes can be. Please note that this example is only meant as a guide to outline how the strategy works, and uses hypothetical values. It doesn't take into account commission costs associated with carrying out the necessary transactions.

Initial Trade

• Company X stock is trading at $50 and you expect it to fall in price but not any lower than $47.
• At the money puts on Company X stock (strike price $50) are trading at $2 and out of the money puts on Company X stock (strike price $47) are trading at $.50.
• You buy 1 at the money put options contract (contract contains 100 options) at a cost of $200. This is Leg A.
• You write 1 out the money put options contract with a strike price of $47 (contract contains 100 options) for a credit of $50. This is Leg B.
• You have now constructed a bear put spread and incurred a net debit of $150.

If Company X stock decreases to $47 by expiration

The options you bought in Leg A will be in the money and worth around $3 each, and the ones written in Leg B will be at the money and worthless. The ones owned will be worth around $300 in total which means a profit of $150 after accounting for your initial investment.

If Company X stock decreases to $48 by expiration

The options you bought in Leg A will be in the money and worth approximately $2 each, while the ones you wrote in Leg B will be out of the money and worthless. The ones you hold will be worth $200 in total, giving you a net profit of $50 after taking your initial investment of $150 into account.

If Company X stock stays at $50, or increases, by expiration

The options in Leg A and Leg B will be worthless. With no returns to come and no liabilities, you have simply lost your initial $150 investment.

If Company X stock increased dramatically, you still wouldn't lose any more than your initial $150 investment. Equally, if Company X stock fell even lower than $47, your profits wouldn't increase above the $150, because the position in Leg B would start to lose you money at the same rate the position in Leg A would make you money.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security < or = Strike Price of Leg B”
• Maximum profit, per option owned, is “(Strike Price of Leg A – Strike Price of Leg B) – (Price of Option in Leg A –Price of Option in Leg B)”
• Maximum loss is limited.
• Maximum loss is made when “Price of Underlying Security > or = Strike Price of Leg A”
• Maximum loss per option owned is “Price of Option in Leg A – Price of Option in Leg B”
• Break-even point is when “Price of Underlying Security = Strike Price of Leg A – (Price of Options in Leg A – Price of Options in Leg B)”

Summary

It's fair to say that this is a straightforward strategy with clear benefits and not much in the way of a downside. It's an excellent strategy to employ if you have a bearish outlook and are reasonably confident you know roughly how far the price of the underlying security will fall.

Your potential profits are limited, but so are your losses, and the upfront costs are relatively low compared to how much you stand to make if the trade works out as planned.