A bear put spread entails the purchase of a put option and the simultaneous sale of another put with the same expiration, but a lower strike price. While it is conceptually similar to buying a standalone put for speculating on potential downside or hedging such risk, a notable difference is that the sale of the lower priced put in a bear put spread offsets part of the cost of the long put position and also caps the strategy’s profit. Thus, this strategy involves giving up some of the possible profits for a lower cost as compared to a standalone put. A bear put spread is also known as a debit (put) spread or a long put spread. (For comparison, see "What is a Bull Put Spread?", "What is a Bull Call Spread?")
Profiting from a Bear Put Spread
Since a bear put spread involves a net cost or debit, the maximum loss that can arise from this strategy is the cost of the trade plus commissions. The maximum gain that can be made is the difference between the strike prices of the puts (less commissions, of course). This risk-reward profile means that the bear put spread should be considered in the following trading situations:
- Moderate downside is expected: This strategy is ideal when the trader or investor expects moderate downside in a stock, rather than a precipitous decline in it. If the trader expected the stock to plunge, standalone puts would be the preferred strategy in order to derive the maximum profit, since profits are capped in a bear put spread.
- Risk is sought to be limited: As this is a debit spread, the strategy’s risk is limited to the cost of the spread. The bear put spread also has a significantly lower degree of risk than a naked (or uncovered) short sale.
- Puts are pricey: If puts are relatively expensive - typically because of high implied volatility - a bear put spread is preferable to buying standalone puts, since the cash inflow from the short put will defray the price of the long put.
- Leverage is desired: For a given amount of investment capital, the trader can get more leverage with the bear put spread than by short-selling the stock.
Let’s say you are a new options trader and want to make an impression on your seasoned colleagues. You identify FlaxNet (a hypothetical stock, we might add) as a candidate for a bearish option trade. FlaxNet is trading at $50, and you believe it has downside risk to $45 over the next month. Since implied volatility in the stock is quite high, you decide that a bear put spread is preferable to buying standalone puts. You therefore execute the following bear put spread:
Buy five contracts of $50 FlaxNet puts expiring in one month and trading at $2.50.
Sell five contracts of $45 FlaxNet puts also expiring in one month, and trading at $1.00.
Since each option contract represents 100 shares, your net premium outlay is =
($2.50 x 100 x 5) – ($1.00 x 100 x 5) = $750.
Consider the possible scenarios a month from now, in the final minutes of trading on the option expiration date:
Scenario 1: Your bearish view proves to be correct, and FlaxNet tumbles to $42.
In this case, the $50 and $45 puts are both in the money, by $8 and $3 respectively.
Your gain on the spread is therefore: [($8 - $3) x 100 x 5] less [the initial outlay of $750]
= $2,500 – $750 = $1,750 (less commissions).
The maximum gain on a bear put spread is realized if the stock closes at or below the strike price of the short put.
Scenario 2: FlaxNet declines, but only to $48.50.
In this case, the $50 put is in the money by $1.50, but the $45 put is out of the money and therefore worthless.
Your return on the spread is therefore: [($1.50 - $0) x 100 x 5] less [the initial outlay of $750]
= $750 – $750 = $0.
You therefore break even on the trade, but are out of pocket to the extent of the commissions paid.
Scenario 3: FlaxNet goes in the opposite direction to the one you had anticipated, and rises to $55.
In this case, the $50 and $45 puts are both out of the money, and therefore worthless.
Your return on the spread is therefore: [$0] less [the initial outlay of $750] = -$750.
In this scenario, since the stock closed above the strike price of the long put, you lose the entire amount invested in the spread (plus commissions).
To recap, these are the key calculations associated with a bear put spread:
Maximum loss = Net Premium Outlay (i.e. premium paid for long put less premium received for short put) + Commissions paid
Maximum gain = Difference between strike prices of puts (i.e. strike price of long put less strike price of short put) – (Net Premium Outlay + Commissions paid)
Break-even = Strike price of the long put – Net Premium Outlay.
In the previous example, the break-even point is = $50 – $1.50 = $48.50.
Advantages Of A Bear Put Spread
- In a bear put spread, as noted earlier, risk is limited to the net premium paid for the position and there is little risk of the position incurring huge losses. There is a situation in which this strategy could accrue significant losses, which would occur if the trader closes the long put position but leaves the short put position open, Doing so would convert the put spread to a put-write strategy, and if the stock subsequently plunges to a price well below the strike price of the short put, the trader may be assigned the stock at a price that is below its current market price.
- The bear put spread can be tailored to a specific risk profile. A relatively conservative trader may opt for a narrow spread where the put strike prices are not very far apart, if the main objective is to minimize the net premium outlay in return for a relatively small gain. An aggressive trader may prefer a wider spread to maximize gains even if it means incurring a higher cost to put on the spread.
- A bear put spread has a quantifiable risk-reward profile, since the maximum possible loss and maximum gain are known at the outset.
- The trader runs the risk of losing the entire premium paid for the put spread if the stock does not decline.
- As the bear put spread is a debit spread, time in not on the trader’s side, as this strategy only has a finite amount of time before it expires.
- There is a possibility of an assignment mismatch if the stock declines sharply; in this case, since the short put may be well in the money, the trader may be assigned the stock. While the long put can be exercised to sell the stock in the event of assignment, there may be a difference of a day or two in settling these trades.
- Since profit is limited with a bear put spread, this is not the optimal strategy if a stock is expected to decline sharply. In the previous example, if the underlying stock fell to $40, a trader who was very bearish and therefore had only purchased the $50 puts would make a gross gain of $10 on a $2.50 investment for a return of 300%, as opposed to the maximum gross gain of $5 on the $1.50 investment in the put spread, a return of 233%.
The bear put spread is a suitable option strategy for taking a position with limited risk on a stock with moderate downside. Its lower level of risk as opposed to shorting the stock as well as the smaller outlay compared to standalone puts are appealing characteristics. However, new option traders should be aware that as a debit strategy, the entire amount invested in a bear put spread can be lost if the stock does not decline as anticipated.
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