<< Basic Option Spread Strategies (Part 1) - Bull Call Spread

Bear Put Spread

Step 1: Buy higher-strike Put option
Step 2: Sell lower-strike Put option with the same expiration date

Characteristics
A Vertical Spread, this is a Debit transaction.

Investor Sentiment
Moderate Bearish Strategy (small debit spread):
It’s considered a bearish strategy because you
profit if the underlying stock price decreases.

Cost, Profit & Loss
Net debit = Lower-strike put options - high-strike put options.
Profit = Difference of two strike prices – net debit (maximum; limited)
Loss = Net debit paid (maximum; limited)

Profit Potential
Maximum profit is reached if the stock price closes below the short (lower-strike) put option strike price on expiration date.

Risks
Maximum loss is reached if the stock price increases above the long (higher-strike) put option strike price at expiration date.

Drawbacks
Lower risk than strictly buying a put option, but limited profit potential. Break-even at upper strike price minus net debit. Similar to a Bull Call Spread, this strategy is a debit spread position. That is, the amount of the sale of the put option position brings in less than is needed to purchase the put option position.

How To Trade
You trade bear put spread in circumstances where you anticipate the underlying asset price to decline. Generally, you select the higher-strike option to be Near-The-Money of the underlying. The short side of the bear put spread involves you selling the lower-strike put option against the long one. You want to select a strike price that is

• Low enough to create a decent upside; and
• High enough so that the premium you’re selling does impact favorably upon the net debit, therefore, your risk and breakeven point.

The optimum time span to trade is about one to three months to expiration. Volatility of the short option is preferably higher than long one.

Bear Put Spread Example

Stock Company Name/Ticker Symbol: Hewlett-Packard (HPQ)
Stock Price: $20.30
Buy Near-The-Money Put Option (Long Position): 10 contracts - Nov $20.00 @ $1.10
Sell Out-of-The-Money Put Option (Short Position): 10 contracts - Nov $17.50 @ $0.30
Put Options Expiration Date: November (Third Friday of the month)

This position is considered a net debit of $0.80, for spread of $2.50. That is the difference between the sale of the out-of-the-money (lower strike) put option and the purchase of the near-the-money (higher strike) put option which results in a negative cash flow (debit) of $0.80 ($1.10 - $0.30). The spread represents the difference between the in-the-money and out-of-the-money strike prices, which are $2.50 apart (Nov $20 put option - Nov $17.50 put option). So, what does all of this translate to for potential profit? Let’s assume the stock price is below the out-of-the-money (lower) put option strike price ($17.50) on the November expiration date. That would translate to a maximum profit of the difference between the strike prices minus the net debit or $2.50 - $0.80 = $1.70 x 10 contract (1,000 shares) for a maximum profit of $1,700 per 10 contracts. The percentage return becomes $1.70/$0.80 x 100% = 212.5%.

Now let’s look at the maximum loss potential should the stock price go above the higher option strike price on the November expiration date. Due to our Bear Put Spread option positions, we have pre-determined the maximum amount we are willing to lose. That maximum loss potential translates to the $0.80 debit spread x 10 contract (1000 shares) = $800 per contract.

By using the Bear Put Spread strategy we have lowered our risk compared to only buying puts exclusively. If we bought the November $20 @ $1.10 put option outright and the stock price is higher than $20 on November expiration date, we would have a potential loss of $1.10 x 10 contracts (1,000 shares) = $1,100. This is a much more significant loss than the $800 potential loss using the Bear Put Spread strategy.

Next : Part 3 - Bull Put Spread

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