Bear Put Spread Explained

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Bear Put Spread

What Is a Bear Put Spread?

A bear put spread is a type of options strategy where an investor or trader expects a moderate decline in the price of a security or asset. A bear put spread is achieved by purchasing put options while also selling the same number of puts on the same asset with the same expiration date at a lower strike price. The maximum profit using this strategy is equal to the difference between the two strike prices, minus the net cost of the options.

As a reminder, an option is a right without the obligation to sell a specified amount of underlying security at a specified strike price.

A bear put spread is also known as a debit put spread or a long put spread.

Key Takeaways

  • 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.

The Basics of a Bear Put Spread

For example, let’s assume that a stock is trading at $30. An options trader can use a bear put spread by purchasing one put option contract with a strike price of $35 for a cost of $475 ($4.75 x 100 shares/contract) and selling one put option contract with a strike price of $30 for $175 ($1.75 x 100 shares/contract).

In this case, the investor will need to pay a total of $300 to set up this strategy ($475 – $175). If the price of the underlying asset closes below $30 upon expiration, the investor will realize a total profit of $200. This profit is calculated as $500, the difference in the strike prices [$35 – $30 x 100 shares/contract] – $300, the net price of the two contracts [$475 – $175] equals $200.

Advantages and Disadvantages of a Bear Put Spread

The main advantage of a bear put spread is that the net risk of the trade is reduced. Selling the put option with the lower strike price helps offset the cost of purchasing the put option with the higher strike price. Therefore, the net outlay of capital is lower than buying a single put outright. Also, it carries far less risk than shorting the stock or security since the risk is limited to the net cost of the bear put spread. Selling a stock short theoretically has unlimited risk if the stock moves higher.

If the trader believes the underlying stock or security will fall by a limited amount between the trade date and the expiration date then a bear put spread could be an ideal play. However, if the underlying stock or security falls by a greater amount then the trader gives up the ability to claim that additional profit. It is the trade-off between risk and potential reward that is appealing to many traders.

Less risky than simple short-selling

Works well in modestly declining markets

Limits losses to the net amount paid for the options

Risk of early assignment

Risky if asset climbs dramatically

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Limits profits to difference in strike prices

With the example above, the profit from the bear put spread maxes out if the underlying security closes at $30, the lower strike price, at expiration. If it closes below $30 there will not be any additional profit. If it closes between the two strike prices there will be a reduced profit. And if it closes above the higher strike price of $35 there will be a loss of the entire amount spent to buy the spread.

Also, as with any short position, options-holders have no control over when they will be required to fulfill the obligation. There is always the risk of early assignment—that is, having to actually buy or sell the designated number of the asset at the agreed-upon price. Early exercise of options often happens if a merger, takeover, special dividend or other news occurs that affects the option’s underlying stock.

Bear Put Spread

The bear put spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term.

Bear put spreads can be implemented by buying a higher striking in-the-money put option and selling a lower striking out-of-the-money put option of the same underlying security with the same expiration date.

Bear Put Spread Construction
Buy 1 ITM Put
Sell 1 OTM Put

By shorting the out-of-the-money put, the options trader reduces the cost of establishing the bearish position but forgoes the chance of making a large profit in the event that the underlying asset price plummets. The bear put spread options strategy is also know as the bear put debit spread as a debit is taken upon entering the trade.

Limited Downside Profit

To reach maximum profit, the stock price need to close below the strike price of the out-of-the-money puts on the expiration date. Both options expire in the money but the higher strike put that was purchased will have higher intrinsic value than the lower strike put that was sold. Thus, maximum profit for the bear put spread option strategy is equal to the difference in strike price minus the debit taken when the position was entered.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying

Limited Upside Risk

If the stock price rise above the in-the-money put option strike price at the expiration date, then the bear put spread strategy suffers a maximum loss equal to the debit taken when putting on the trade.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying >= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the bear put spread position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Long Put – Net Premium Paid

Bear Put Spread Example

Suppose XYZ stock is trading at $38 in June. An options trader bearish on XYZ decides to enter a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for $100 at the same time, resulting in a net debit of $200 for entering this position.

The price of XYZ stock subsequently drops to $34 at expiration. Both puts expire in-the-money with the JUL 40 call bought having $600 in intrinsic value and the JUL 35 call sold having $100 in intrinsic value. The spread would then have a net value of $5 (the difference in strike price). Deducting the debit taken when he placed the trade, his net profit is $300. This is also his maximum possible profit.

If the stock had rallied to $42 instead, both options expire worthless, and the options trader loses the entire debit of $200 taken to enter the trade. This is also the maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the bear put spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Bear Spread on a Credit

The bear put spread is a debit spread as the difference between the sale and purchase of the two options results in a net debit. For a bearish spread position that is entered with a net credit, see bear call spread.

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Bear put spread

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To profit from a gradual price decline in the underlying stock.

Explanation

Example of bear put spread

Buy 1 XYZ 100 put at (3.20)
Sell 1 XYZ 95 put at 1.30
Net cost = (1.90)

A bear put spread consists of one long put with a higher strike price and one short put with a lower strike price. Both puts have the same underlying stock and the same expiration date. A bear put spread is established for a net debit (or net cost) and profits as the underlying stock declines in price. Profit is limited if the stock price falls below the strike price of the short put lower strike), and potential loss is limited if the stock price rises above the strike price of the long put (higher strike).

Maximum profit

Potential profit is limited to the difference between the strike prices minus the net cost of the spread including commissions. In the example above, the difference between the strike prices is 5.00 (100.00 – 95.00 = 5.00), and the net cost of the spread is 1.90 (3.20 – 1.30 = 1.90). The maximum profit, therefore, is 3.10 (5.00 – 1.90 = 3.10) per share less commissions. This maximum profit is realized if the stock price is at or below the strike price of the short put (lower strike) at expiration. Short puts are generally assigned at expiration when the stock price is below the strike price. However, there is a possibility of early assignment. See below.

Maximum risk

The maximum risk is equal to the cost of the spread including commissions. A loss of this amount is realized if the position is held to expiration and both puts expire worthless. Both puts will expire worthless if the stock price at expiration is above the strike price of the long put (higher strike).

Breakeven stock price at expiration

Strike price of long put (higher strike) minus net premium paid

In this example: 100.00 − 1.90 = 98.10

Profit/Loss diagram and table:

Buy 1 XYZ 100 put at (3.20)
Sell 1 XYZ 95 put at 1.30
Net cost = (1.90)
Stock Price at Expiration Long 100 Put Profit/(Loss) at Expiration Short 95 Put Profit/(Loss) at Expiration Bear Put Spread Profit/(Loss) at Expiration
104 (3.20) +1.30 (1.90)
103 (3.20) +1.30 (1.90)
102 (3.20) +1.30 (1.90)
101 (3.20) +1.30 (1.90)
100 (3.20) +1.30 (1.90)
99 (2.20) +1.30 (0.90)
98 (1.20) +1.30 +0.10
97 (0.20) +1.30 +1.10
96 +0.80 +1.30 +2.10
95 +1.80 +1.30 +3.10
94 +2.80 +0.30 +3.10
93 +3.80 (0.70) +3.10
92 +4.80 (1.70) +3.10

Appropriate market forecast

A bear put spread performs best when the price of the underlying stock falls below the strike price of the short put at expiration. Therefore, the ideal forecast is “modestly bearish.”

Strategy discussion

Bear put spreads have limited profit potential, but they cost less than buying only the higher strike put. Since most stock price changes are “small,” bear put spreads, in theory, have a greater chance of making a larger percentage profit than buying only the higher strike put. In practice, however, choosing a bear put spread instead of buying only the higher strike put is a subjective decision. Bear put spreads benefit from two factors, a falling stock price and time decay of the short option. A bear put spread is the strategy of choice when the forecast is for a gradual price decline to the strike price of the short put.

Impact of stock price change

A bear put spread rises in price as the stock price falls and declines in price as the stock price rises. This means that the position has a “net negative delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bear put spread consists of one long put and one short put, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bear put spread consists of one long put and one short put, the price of a bear put spread changes very little when volatility changes. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since a bear put spread consists of one long put and one short put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or above the strike price of the long put (higher strike price), then the price of the bear put spread decreases with passing of time (and loses money). This happens because the long put is closest to the money and decreases in value faster than the short put. However, if the stock price is “close to” or below the strike price of the short put (lower strike price), then the price of the bear put spread increases with passing time (and makes money). This happens because the short put is now closer to the money and decreases in value faster than the long put. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bear put spread, because both the long put and the short put decay at approximately the same rate.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put in a bear put spread has no risk of early assignment, the short put does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bear put spread (the lower strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by selling the long put to close and buying the short put to close. Alternatively, the short put can be purchased to close and the long put can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put. Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or above the higher strike price, below the higher strike price but not below the lower strike price or below the lower strike price. If the stock price is at or above the higher strike price, then both puts in a bear put spread expire worthless and no stock position is created. If the stock price is below the higher strike price but not below the lower strike price, then the long put is exercised and a short stock position is created. If the stock price is below the lower strike price, then the long put is exercised and the short put is assigned. The result is that stock is sold at the higher strike price and purchased at the lower strike price and no stock position is created.

Other considerations

The “bear put spread” strategy has other names. It is also known as a “debit put spread” and as a “long put spread.” The term “bear” refers to the fact that the strategy profits with bearish, or falling, stock prices. The term “debit” refers to the fact that the strategy is created for a net cost, or net debit. Finally, the term “long” refers to the fact that this strategy is “purchased,” which is another way of saying that it is created for a net cost.

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