Two of the best features of options are that they afford an investor or trader the opportunity to achieve certain objectives and/or play the market in certain ways that they might not otherwise be able to. For example, if an investor is bearish on a particular stock or index, one of the choices is to sell short shares of the stock. While this is a perfectly viable investment alternative, it does have some negatives. First off, there are fairly sizable capital requirements. Secondly, there is technically unlimited risk, because there is no limit as to how far the stock could rise in price after the investor sold short the shares. Fortunately, options offer alternatives to this scenario.

SEE: Options Hazards That Can Bruise Your Portfolio

The Put Option
One alternative to shorting a stock is to purchase a put option, which gives the buyer the option, but not the obligation, to sell short 100 shares of the underlying stock at a specific price - known as the strike price - up until a specific date in the future (known as the expiration date). To purchase a put option, the investor pays a premium to the option seller. This is the entire amount of risk associated with this trade. The bottom line is that the buyer of a put option has limited risk and essentially an unlimited profit potential (profit potential is limited only by the fact that a stock can only go to zero). Nevertheless, despite these advantages, buying a put option is not always the best alternative for a bearish trader or investor who desires limited risk and minimal capital requirements.

Mechanics of the Bear Put Spread
One of the most common alternatives to buying a put option is a strategy known as a bear put spread. This strategy involves buying one put option with a higher strike price and simultaneously selling the same number of put options at a lower strike price. As an example, consider the possibility of buying a put option with a strike price of $50 on a stock trading at $51 a share.

SEE: Option Spreads

Let's assume that there are 60 days left until option expiration and that the price of the 50 strike price put option is $2.50. In order to purchase this option, a trader would pay a premium of $250. Then, for the next 60 days he or she would have the right to sell short 100 shares of the underlying stock at a price of $50 a share. So, if the price of the stock fell to $45, $40, $30 or even lower, the buyer of the put option could exercise his or her put option and sell short 100 shares at $50 a share. He or she could then buy back the shares at the current price and pocket the difference between $50 a share and the price he paid to buy back the shares.

The other, more common, alternative would be to sell the put option itself and pocket the profit. For example, if the stock fell to $40 a share, the buyer who bought the 50 put option at $2.50 would be able to sell the put option for $10 or more, resulting in a substantial profit.

Advantages of the Bear Put Spread Alternative
The problem with buying or selling a put option is that the breakeven price for the trade in the example above is $47.50 per share, which is calculated by subtracting the put premium paid ($2.50) from the strike price ($50). To look at it another way, the stock must decline. Also, a trader may not be looking for a substantial decline in the price of the stock, but rather something more modest.

In this case, an individual might consider the bear put spread as an alternative. Building on the same example, an individual may buy the same 50 strike price put option for $2.50 but will also simultaneously sell the 45 strike price put option and receive $1.10 of premium. As a result, the trader only pays a net cost of $140 to purchase the spread ($2.50 - $1.40 x 100 shares). There are two positives and one negative associated with this alternative compared to simply buying the 50 strike price put for $250.

  • Advantage No.1: The trader has reduced the cost of the trade by 44% (from $250 to $140).
  • Advantage No.2: The breakeven price rises from $47.50 for the long put trade to $48.60 for the bear put spread (the breakeven price for the put spread is arrived at by subtracting the price of the spread ($1.40) from the higher strike price ($50 - $1.40 = 48.60).

As a result of entering the bear put spread, this trader has less dollar risk and a higher probability of profit. If the trader does not expect the price of the stock to decline much below 45 by option expiration, this may be an outstanding alternative.

Disadvantage of the Bear Put Spread
There is one important negative associated with this trade compared to the long put trade: the bear put trade has a limited profit potential. The potential is limited to the difference between the two strikes minus the price paid to purchase the spread.

In this case, the maximum profit potential is $360 (5-point spread - 1.40 points paid = $3.60). This trade will show a profit at option expiration if the stock is at any price below the breakeven price of $48.60 a share. The maximum profit of $360 will be reached if the stock is at or below the lower strike price of $45 a share at expiration. While the profit potential is not unlimited, the trader still has the potential to make a profit of 257% ($360 profit on a $140 investment) if the stock declines roughly 12% (from $51 to $45).

The Bottom Line
The bear put spread offers an outstanding alternative to selling short stock or buying put options in those instances when a trader or investor wants to speculate on lower prices, but does not want to commit a great deal of capital to a trade and/or does not necessarily expect a massive decline in price.

In either of these cases, a trader may give him or herself an advantage by trading a bear put spread, rather than simply buying a naked put option.

Related Articles
  1. Options & Futures

    The Basics Of Option Price

    Options can be an excellent addition to a portfolio. Find out how to get started.
  2. Options & Futures

    Introducing The VIX Options

    Discover a new financial instrument that provides great opportunities for both hedging and speculation.
  3. Options & Futures

    4 Reasons To Hold Onto An Option

    There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
  4. Options & Futures

    Profiting From Stock Declines: Bear Put Spread Vs. Long Put

    If you're bearish, you should compare the risk/reward characteristics of these two strategies.
  5. Options & Futures

    Stock Option Expiration Cycles

    Understanding expiration cycles is just one more way to help you increase your success rate when trading options.
  6. Mutual Funds & ETFs

    The 3 Best Downside Protection Equity Mutual Funds

    Learn how it is possible to profit in a bear market by owning the correct selection of mutual funds that provide downside protection and opportunity.
  7. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  8. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  9. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  10. Investing News

    With Short Interest Surging, Is it Time to Buy?

    What do you think the smart money is doing when the market moves higher? Apparently, they're building short positions.
RELATED FAQS
  1. What techniques are most useful for hedging exposure to the telecommunications sector?

    A couple of option strategies can be used to hedge exposure to the telecommunications sector. Certain option strategies can ... Read Full Answer >>
  2. What are the most effective hedging strategies to reduce market risk?

    There are a number of effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being ... Read Full Answer >>
  3. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  4. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  5. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  6. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center