Bear Put Spread Options Strategy

Submitted by admin on Thu, 11/25/2021 - 20:42

To cover some of the upfront cost, a bear put spread consists of purchasing one put and selling another put at a lower strike.


A vertical spread called a bear put spread is a sort of vertical spread.
It entails purchasing one option in the hopes of benefiting from a drop in the underlying stock, and then writing another put with the same expiration but a lower strike price to offset part of the cost.
This method necessitates a net cash outlay (net debit) from the beginning due to the manner the strike prices are chosen.


The bear put spread works similarly to its long put component as a standalone strategy if the stock swings down toward the lower strike price.
In contrast to a simple long put, however, the likelihood of higher earnings ends there.
This is part of the tradeoff; the short put premium lowers the strategy's cost while also limiting the gains.


A alternate set of strike prices might work, as long as the short put strike is lower than the long put strike.
It's all about balancing tradeoffs and sticking to a realistic projection.

 

EXAMPLE


1 SPY 400 put long

1 SPY 380 put short


GAIN MAXIMUM


Net premium paid for high strike vs. low strike


LOSS MAXIMUM


Payment of the net premium


The larger the possible maximum profit, the lower the short put strike; however, this benefit must be balanced against the drawback of receiving a lesser amount of premium.


Comparing this method to the bear call spread is instructive.
Once the net cost to carry is factored in, the profit/loss payout profiles are identical.
The primary distinction is in the timing of the cash flows.
The bear put spread necessitates a known initial expenditure in exchange for an uncertain ultimate return, whereas the bear call spread generates a known initial cash inflow in exchange for a probable outlay later.

Outlook


During the duration of the options, look for a constant or dropping stock price.


While the longer-term view is secondary, if an investor is negative on the stock's future, there is a case to be made for evaluating another option.
To predict when an expected rise would finish and the ultimate collapse would begin, meticulous targeting would be required.

Summary


To cover some of the upfront cost, a bear put spread consists of purchasing one put and selling another put at a lower strike.
If the stock price falls, the spread usually makes money.
The profit potential is low, but so is the danger if the stock rises abruptly.

Motivation


Profit from the underlying stock's short-term drop.

Variations


Depending on how the strike prices for the long and short positions are chosen, a vertical put spread can be a bullish or bearish strategy.
For the bullish counterpart, see bull put spread.

Maximum Loss


There is a limit to the amount of money that may be lost.
The worst-case scenario is that the stock closes above the higher (long put) strike price at expiry.
In that instance, both put options expire worthless, and the loss is limited to the initial investment (the debit).

Maximum Gain


The maximum profit is capped.
The best case scenario is that the stock price at expiry is lower than the lower strike.
Even if the stock continues to fall, the top limit of profitability has been achieved.
The investor would execute the long put component and presumably get assigned on the short put if the stock price was below both strike prices at expiry.
As a result, the stock is sold at a higher price (long put strike) and concurrently purchased at a lower price (short put strike).
The difference between the two strike prices, minus the initial outlay (the debit) paid to construct the spread, is the maximum profit.

Profit/Loss


This strategy's prospective profit and loss are both quite restricted and highly defined.
The initial net premium determines the maximum risk, while the short put strike price determines the upper limit beyond which additional stock price depreciation will not boost profitability.
The maximum profit is restricted to the difference in strike prices less the debit paid to open the trade.


By selecting multiple strike prices, the investor can change the profit/loss bounds.
Each option, on the other hand, offers a typical risk/reward tradeoff: more chances and risk vs fewer opportunities and danger.

Breakeven


If the stock price is below the higher strike by the amount of the initial outlay at expiration, this method breaks even (the debit).
The short put would therefore expire worthless, and the intrinsic value of the long put would equal the debit.


Long put strike - net debit paid = breakeven Volatility


All other things being equal, a smidgeon.
Because the strategy includes shorting one put and longing another with the same expiration, volatility movements on the two contracts may partially negate each other.


However, the stock price might fluctuate in such a way that a change in volatility affects one price more than the other.

Time Passes


The position suffers from the passage of time, but not as much as a simple long put position.
The effects of time decay on the two contracts may negate each other to a substantial degree because the strategy entails being long one put and short another with the same expiration.


Regardless of the theoretical influence of time erosion on the two contracts, it is reasonable to believe that time is a negative factor.
This technique necessitates a one-time non-refundable investment.
If there are any returns on the investment, they must be realized before the investment expires.
As the deadline for making any profits approaches, so does the deadline for achieving any profits.

Assignment Danger


Yes.
While early assignment is feasible at any moment, it is most common when a put option is deep into the money.
However, keep in mind that using the long put to cover the short put assignment would need funding a long stock position for one business day.


Also, keep in mind that any circumstance in which a company is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, can fundamentally destabilize traditional expectations for early execution of options on the stock.

Risk of Expiration


Yes.
This method carries additional risk if it is retained until it expires.
The investor will not know whether or not the short put was allocated until the following Monday.
If the stock is trading slightly below, at, or just above the short put strike, the problem is magnified.
It's possible that making a mistake in either direction will cost you money.


Assume the long put is deep in the money on Friday afternoon, and the short put is roughly at the money.
Assignment (stock purchase) is uncertain, but exercise (stock selling) is.
If the investor predicts incorrectly, the new position the next week will be incorrect as well.
If assignment is expected but does not occur, the investor will not be aware of the unexpected net short stock position until the following Monday, and will be exposed to a stock gain over the weekend.
Assume the investor decided to take a chance on assignment and bought the stock on the open market to close the position.
If assignment occurred after all, the investor will have purchased the identical shares twice, resulting in a net long stock position and exposure to a stock price decrease on Monday.


There are two options for being ready: narrow the spread early or be ready for either outcome on Monday.
In any case, it's critical to keep an eye on the stock, particularly on the last day of trading.