Define Bear Put Spread

What Is a Bear Put Spread and How Does It Work?

A bear put spread is an option strategy in which an investor or trader anticipates a moderate-to-large decrease in the price of a security or asset and seeks to lower the cost of holding the option contract. A bear put spread is created by buying put options and selling the same amount of puts on the same asset at a lower strike price on the same expiration date. The difference between the two strike prices, minus the net cost of the options, is the maximum profit possible with this technique.

A put option offers the holder the right, but not the responsibility, to sell a certain amount of the underlying securities at a predetermined strike price at or before the option expires.

A debit put spread or a long put spread is another name for a bear put spread.

TAKEAWAYS IMPORTANT

• A bear put spread is an options strategy used by a bearish investor looking to maximise profits while limiting losses.

• A bear put spread includes buying and selling puts for the same underlying asset with the same expiration date but different strike prices at the same time.

• When the price of the underlying securities falls, a bear put spread makes money.

Bear Put Spread Fundamentals

Consider the case of a stock that is now trading at $30. Purchase one put option contract with a strike price of $35 for $475 ($4.75 x 100 shares/contract) and sell one put option contract with a strike price of $30 for $175 ($1.75 x 100 shares/contract) to create a bear put spread.

In this situation, the investor will have to pay a total of $300 ($475 – $175) to put up this method. The investor will get a total profit of $200 if the underlying asset's price closes below $30 at expiration. This profit is computed as $500 ($35 – $30) x 100 shares/contract – $300, and the net price of the two contracts [$475 – $175] = $200.

The Benefits and Drawbacks of a Bear Put Spread

The key benefit of a bear put spread is that it lowers the overall risk of the deal. The cost of acquiring the put option with the higher strike price is covered by selling the put option with the lower strike price. As a result, the net capital expenditure is smaller than if you bought a single put outright. It also bears significantly less risk than shorting a company or investment since the risk is confined to the bear put spread's net cost. When selling a stock short, the risk is theoretically limitless if the stock rises.

A bear put spread might be an excellent play if the trader feels the underlying stock or investment will decline by a specific amount between the trading date and the expiry date. If the underlying stock or investment falls by a larger amount, the trader forfeits the right to claim the additional profit. Many traders are attracted to the trade-off between risk and possible return.

Pros

• It's less dangerous than traditional short-selling.

• In moderately dropping markets, this strategy works effectively.

• Limits losses to the amount paid for the options in the first place.

Cons

• Early assignment risk

• If the asset's value skyrockets, it's a risky bet.

• Profits are limited to the difference in strike prices.

If the underlying share closes at $30, the lower strike price, at expiry, the profit from the bear put spread reaches its maximum. There will be no more profit if it closes below $30. There will be a decreased profit if it closes between the two strike prices. And if it closes over the higher strike price of $35, the whole money invested to buy the spread would be lost.

Option holders also have no influence over when they will be obliged to satisfy the obligation, as they do with any short position. Early assignment, or needing to acquire or sell the allocated quantity of the asset at the agreed-upon price, is always a possibility. Early exercise of options is common when the underlying stock of the option is affected by a merger, takeover, special dividend, or other news.

Example of a Bear Put Spread in the Real World

Let's suppose Levi Strauss & Co. (LEVI) is now trading at $50 on October 20, 2019. Winter is approaching, and you don't think the jeans company's stock will do well. Instead, you believe it will be moderately depressing. As a result, you purchase a $40 put for $4 and a $30 put for $1. On November 20, 2019, both contracts will be up for renewal. You would lose $3 ($4 – $1) if you bought the $40 put and sold the $30 put at the same time.