Buying a put option provides an individual with the opportunity to profit from a decline in the price of the underlying stock, stock index or futures contract. In so doing, a put buyer also enjoys risk limited to the premium paid, while profits to the upside are increased through leverage. However, the reality of options trading is that trading is a tradeoff. With virtually every strategy there are alternatives, and any time you gain an advantage somewhere you give up an advantage someplace else. This forces traders to identify their objectives at the time they enter a trade. (To learn more about options, read the Options Basics Tutorial.)
This tradeoff is never more clear than when a trader is looking to profit on a falling stock. This can be accomplished with both a bear put spread or a simple put option. Read on to find out how each of these strategies works and how to determine which one is likely to provide the best results in a given situation.
Put Option Vs. Bear Put Spread
A trader who expects a given stock to decline and who wishes to profit from that decline in price might consider buying a put option, which gives him or her the right to sell the underlying stock at a specific price regardless of how far the underlying stock may fall in price.
As an alternative, the trader may instead consider entering into a position known as a bear put spread. This position is entered by buying a put option with a higher strike price and simultaneously selling another put option with a lower strike price. The buyer of the put spread enjoys less risk and a closer breakeven price for the trade based on the fact that he or she collected premium by writing an option. The disadvantage is that the profit potential is lower than it would be for a put option because it is limited to the difference between the strike prices and the net premium paid. In other words, a bear put spread involves a limited profit potential. This illustrates the concept of needing to accept tradeoffs in selecting between different option trading strategies. (For further reading, be sure to read the Options Spreads Tutorial.)
There are several scenarios whereby a bear put spread might make more sense than the purchase of a put option:
- The trader expects a downward movement in price but expects a decline of a limited magnitude.
- The trader views the price trend as negative but has no expectation in terms of the magnitude of any impending price movement, only that he expects some price movement to the downside.
If a trader truly expects a given stock or futures market to plunge sharply to lower price levels, then the purchase of a put option makes a great deal of sense as it offers the maximum profit potential. However, traders do not in every case have an expectation of sharply lower price levels. Sometimes, a trader believes that the underlying security will decline in price but has no real way to effectively estimate how far the security may fall in price. In this case, a bear put spread may make a great deal of sense.
Bear Put Spread Example
Consider a stock trading at $52.50 that has options trading on it that have 60 days left until option expiration. Let's assume the following:
- The 60-day put option with a strike price of 55 is trading at a price of $5.40.
- The 60-day option with a strike price of 50 is trading at a price of $3.
Each stock option is for 100 shares of the underlying stock; therefore, the premium paid to buy a particular option is simply the price of the option multiplied by 100. The 55 strike price put costs $540 and the 50 strike price put costs $300.
So, let's say that Trader A is expecting a massive decline in the price of the stock. He could simply buy the 50 strike price put for $300 and would have unlimited profit potential below the breakeven price of $47 for the stock (the breakeven price for a put option purchase equals the strike price minus the premium received, or in this example the strike price of $50 minus the premium of $3).
Trader B might enter the more conservative - albeit more expensive - play and buy the 55 strike price put option for $540. The disadvantage is that this trade costs $540 instead of the $300 cost for the 50 strike price put. However, Trader B enjoys a higher breakeven stock price of $49.60 (the strike price of 55 minus the premium of $5.40). So what is wrong with either of these possibilities? And why might a trader consider a bear put spread to be preferable? Let's first consider what would have to happen in order for these two long put example trades to make a profit.
Making a Profit on a Long Put
If the 50 strike price put was purchased, the stock would have to fall 10% in order to reach the breakeven price of $47. If the 55 strike price put was purchased, the stock would have to fall 5.3% in order to reach its breakeven price of $49.60. As an alternative to these two possibilities, Trader C could enter into a bear put spread by buying the 55 strike price put at $5.40 and simultaneously selling the 50 strike price put at $3. This spread would cost the difference between the two premiums, or $240 ($5.40 - $3 x 100 shares). The maximum profit potential for a bear put spread is the difference between the strike prices minus the premium paid. So for this example, the bear put spread the profit potential would be $260 (55 - 50 - 2.40 x 100 = $260).
So why might the bear put spread with limited profit potential be preferable? To answer this question, let's consider what would happen to these trades if the underlying stock simply drifted lower and closed at $50 a share at the time of option expiration:
- With the price of the stock at $50 at option expiration, the 55 strike price put would be worth $5.
- With the price of the stock at $50 at option expiration, the 50 strike price put would expire worthless.
Now let's consider the ramifications for our example trades:
- Trader A, who bought the 50 strike price put, would lose the entire $300 premium he paid (100% of his investment) because the option that he purchased for $3 expired worthless.
- Trader B, who bought the 55 strike price put, would lose $40 (7.4% of her investment) because the option that she purchased for $5.40 would be worth only $5 at expiration.
- Trader C, who bought the 55/50 bear put spread, would have ended with a profit of $260 (or 108.3%). He would have lost $40 on the 55 strike price put option that he purchased but would have kept the entire $300 of premium he received for writing the 50 strike price put.
In this example, the underlying stock declined by 4.5%, from $52.50 a share to $50 a share, between the time the option trade was entered and the time of option expiration. The ramifications of this seemingly minor price movement for each of the option trades we have discussed could hardly be more pronounced:
- Trader A lost 100%
- Trader B lost 7.4%
- Trader C gained 108%
So, as it turned out, Trader C - the one who took the least aggressive position of the three - came out far ahead. This will not always be the case. Nevertheless, the point here is to illustrate that there are times when the less aggressive bear put spread may be preferable to a naked long put position. Note also that if the stock had rallied sharply and both the 55 and 50 strike price put options expired worthless, the buyer of the 55 put would have lost $540, the buyer of the 50 put would have lost $300 and the buyer of the 55/50 bear put spread would have lost only $240. So, even in the worst-case scenario, the buyer of the bear put spread would have suffered the smallest dollar loss.
It is not possible to know trade outcomes in advance. As a result, it is up to the trader to decide in each case what position offers the most favorable tradeoff between risk and reward in each instance. If you find yourself bearish on a particular stock, stock index or futures contract but do not have a specific downside price target, you might be wise to compare the reward and risk characteristics of a bear put spread to those of an outright short position or to that of buying a long put.
For more on using options to manage risk, and profit from speculation, read The Four Advantages Of Options.
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