Understanding and using bear put spread

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If you are wondering what this term means, it’s one of the popular strategies in the world of options trading when a bearish trader wants to maximise profits while keeping losses at a minimum. This is a strategy that comes in handy for a bearish market, when an investor is speculating that the price of a security is going down.

What is a bear put spread used for, and how?

A Bear Put Spread is used when someone wishes to take advantage of security price dropping but not in a big way. So, what is a bear put spread procedure and what steps are involved?  The two steps are carried out simultaneously – buying a higher strike price put option while also selling a lower priced one. The underlying asset, ie, the stock, is the same for both puts, and their expiration is on the same date.

For a comprehensive understanding of bear put spread option strategy, one must first understand options and the two types involved: puts and calls. A put option lets the owner sell the asset underlying at the strike price in the contract till the date that it expires. On the other hand, a call option lets the owner buy the asset underlying at the strike price in the contract, till the date it expires. 

The higher priced put is the in the money (ITM) put while the lower is the out of the money (OTM) option. However, a bear put spread needn’t necessarily employ ITM or OTM but any two put options. When it comes to the ITM, the strike price has already been overtaken by the current price of stock. An OTM has a strike price that the stock is yet to reach, meaning it has no value intrinsically.

What does the Bear Put Spread strategy result in?

The bear put spread option strategy results in a net debit. This net debit is computed when the lower strike price is deducted from the higher price. The optimum amount a trader may lose on the bear put spread strategy is the amount he or she paid for it. This is the net debit.

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Profit or loss from bear put spread option strategy

What is a bear put spread advantage? When the price falls along expected lines, the trader is able to make a profit and restrict losses. If the price falls way too much, ie, more than it was expected to, then there won’t be a profit. So, the answer to what is a bear put spread is that it is a fine balance between reward and risk.

If the stock price increases above the ITM option, the loss then is equal to the debit. If the stock price is above the OTM option and lower than the ITM, then loss results if charges paid to structure the position are higher than the strike price difference.

Instances of bear put spread

Let’s assume a stock X is trading right now at Rs 50. A Rs 40 put price is Rs 4 and a Rs 30 put price is Rs 1. Buying the Rs 40 put while also selling the Rs 30 put means a net debit of Rs 3. This the maximum loss that would occur if the stock closes on expiration above Rs 40.

The maximum gain would be Rs 7, which would happen if the stock closes on expiration less than or equal to Rs 30. The scenario is you buy the stock at Rs 30, sell at Rs 40 and deduct the Rs 3 premium you paid. The maximum gain then is the difference in strike prices munus the net debit.

If you want to break even on such a trade, in the above example, your break would even be Rs 37. The Rs 40 option would be worth Rs 3, which is equal to the premium, while the Rs 30 would have no worth on expiration. The net debit deducted from the higher strike is the breakeven.

Wrapping up

A bear put spread strategy is one employed by traders when they want to minimise losses while optimising profits. It is a fine balance between risk and reward, and is perceived as a bearish strategy.

If you want to try your hand at options trading and apply strategies like the bear put spread, you could open a demat and trading account online and receive expert advice and advisories on how to go about the process. It helps to do your research and stay agile before you get going.

A quick recap

  • A bear put spread is an options strategy implemented by a bearish investor who wants to maximize profit while minimizing losses.
  • A bear put spread strategy involves the simultaneous purchase and sale of puts for the same underlying asset with the same expiration date but at different strike prices.
  • A bear put spread nets a profit when the price of the underlying security declines.
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