What is a Bear Put Spread in Options Trading Strategy?
If you're wondering what the term "bear put spread" means, then let us tell you, this is one of the popular options spread strategies in the trading world where bearish traders want to maximise their profits with minimal losses.
This strategy is useful in a bearish market when investors assume that the price of a security is falling.
The main idea of a bear put spread is that you need to buy the put that's higher in strike price and then sell the same with a lower strike price. The goal is to lower the stock price to equal or below the lower strike price with the closing price (at expiration).
The spread is vertical, and both strikes expire in the same period. A short put with a lower strike is less valuable than a long one with a higher strike. A net debit occurs because the amount paid to sell the lower strike put option is less than the amount paid for the higher strike put option.
Interestingly, even beginners can jump into this strategy and make money. This strategy has a simple configuration with two basic trades, making it ideal for any investor. However, there is a limit to the maximum return an investor can achieve through this strategy. So, it's a great way to still profit while limiting the costs involved.
Also Read: Everything you need to know about Bear Trap
When is a Bear Put Spread in Options Trading Strategy Used?
The idea behind using a Bear Put Spread strategy is to benefit from the decline in the underlying security price. Ideally, a good time to use this strategy is when an investor expects the price of such a security to drop slightly.
To better understand the bear put option spread strategies, you need to understand options.
- The options contract has two main options: puts and calls. A put option allows a trader to sell the underlying asset of an option at a specified strike price before the option expires. A call allows a trader to purchase an asset at a specified price before the option expires.
- A common strategy for bear put spread is to buy a put with a higher strike price and then sell a lower strike. The prime goal is to watch the stock fall and close at any particular point above or close to the lower strike price during the expiration time.
- If a stock closes below the lower stock price, a trader benefits from the strike price, subtracting the premium paid initially.
How to Properly Use a Bear Put Spread Strategy?
Investors need to enter two trades to apply and execute this strategy in real market conditions. These deals include:
- You buy the money put option
- You sell a put that's lower in strike price
Both options must have the same expiration date and be established on the same underlying security. As a result of these trades, the investor creates a net debit spread. This is because the selling price of the option will be higher than the value received when the option was written. Investors have the right to choose the strike price they want to use the option.
However, it is ideal to choose a strike price close to the underlying security price. It should be as close to the expected lifetime of the option as possible. A lower strike price will give you a higher return. Although, at the same time, the credit received to cancel the debit spread will be smaller.
Risk vs Reward of Using Bear Put Spread Strategy
A bear put spread in options trading strategy tends to be quite profitable if the value of the underlying stock declines. It can be set up as one transaction but always on the debit (net cash outflow). A put with a higher strike price is always bought higher than the reward premium you would get from selling a put with a lower strike price.
The loss with the bear put spread strategy usually happens when the underlying stock price is higher than the strike price. When both options expire due to lack of value, the total net debit paid for the bearish vertical spread will get lost.
The benefit of this bearish vertical spread usually takes place when the underlying stock expires in-the-money or falls below the low strike price. This happens regardless of how much the underlying stock has fallen. If the underlying stock is between the strike price when the put option expires, then the bought put is in-the-money and equals intrinsic value. The written put will have no value if it's out-of-the-money.
The bear put spread is one of the most effective option spread strategies since it offers a great alternative to short stock selling or buying put options. When an investor or a trader wants to speculate at a lower price but doesn't want to invest heavily in the trade or necessarily expect a mammoth price drop, this strategy can help. As compared to costs, the profits are generally larger in quantum.
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Frequently Asked Questions
A strike price is an initial price at which the derivative can be sold or bought (exercised).
Bull vertical spread requires simultaneous buying and selling options with various strike prices, but it must be of the same expiration date and class.
Since bear put spread and bear call spread are based on a bearish market outlook, investors can choose between the two depending on their experience and niche. But, again, you can contact reputable financial advisors to make informed decisions about choosing the perfect strategy based on your risk appetite, financial strengths and investment goals.
Here's how to calculate a bear put spread strategy:
- Maximum Loss: Net Premium Paid + Commissions Paid
- Maximum Profit: Call options strike price difference - (net debit premium + commissions paid)
- No profit/loss: Long put option strike price - net premium