Getting to know the bear put spread strategy
What is a bear put spread?
There are many strategies that an investor or a trader can use when it comes to options. One of them includes the bear put spread, which is also known as long put spread or debit put spread. It involves security or asset price decline that ranges from moderate to massive. The aim is to lessen the cost of holding the option trade. How can one carry this out? One can buy put options and sell with the same number of puts on a similar asset, and it should also have the same expiration date at a declined strike price. We can compare the maximum profit when this strategy is used with the difference between two strike prices with the options net cost subtracted. What is a put option anyway? The holder has the right but is not obliged to sell a particular amount of underlying security at a particular strike price before or during the option expires.
Let us cite an example.
Before we begin, let us stress that the stock is currently trading at $30. Let us say that an options trader wants to use a bear put spread. He can do that by buying one put option contract with a $35 strike price for a cost of $475. The equation would then be $4.75 x 100 shares/ contract. At the same time, he also needs to sell one put option contract at a strike price of $30 for the cost of $175. Here, the equation would then be $1.75 x 100 shares/contract.
If we think about it, the investor needs to pay $300 to use the strategy because $475 - $175 = $300. The investor will get a total of $200 profit if the underlying asset closes lower than $30 as it expires. We calculate this profit as $500, the difference between $35 and $30 multiplied by 100 shares per contract minus $300, the net price for two contacts is $200 ($475 - $175).
The pros and cons of the bear put spread.
Let us start on a positive note. On one hand, we know that the bear put spread strategy is less risky compared to simple short selling. If the market is declining modestly, this strategy might be a great option to use. Also, this will limit the losses regarding the net amount paid for the options.
On the other hand, one should know that there is a risk of early assignment. Also, it is risky to use if the asset skyrockets. Also, we said that this limits losses. However, it also limits the profits regarding the difference in the strike prices.
How it can all turn out
Our
previous example tells us that the bear put spread reaches the limit if the
underlying security closes at $30, which is the lesser strike price, during the
expiration date. However, if it closes lower than $30, there is no additional
profit. A reduced profit is what one gets if it closes between the strike
prices. Finally, if it closes higher than $35, the loss will equal the whole
amount spent for that spread.
