Understanding the Bear Put Spread Strategy: A Complete Guide
Understanding the Bear Put Spread Strategy: A Complete Guide
Options traders use different investment strategies to earn guaranteed returns. The bear put spread strategy is common among options investors. It helps investors minimize risks when the price of an asset plummets in the market. The best part about this strategy is that you can earn returns even when the market is bearish. Read on to understand what a bear put spread is in detail.
What is a Bear Put Spread?
This is a bearish trading strategy used by options investors. It is usually implemented when the investors expect a decline in the price of an asset. Investors might want to reduce the cost of holding an option contract. It involves buying and selling the same number of put options with similar expiration dates. You already know that a put option allows you to sell the underlying asset at a predetermined price (strike price) on a future date, known as the expiration date. You purchase put options with a higher strike price in the bear put spread strategy. However, you must write off the same number of put options with a lower strike price.
Basics of a Bear Put Spread
A bear put spread is implemented when one accepts a marginal drop in the asset’s price. It involves buying and selling put options with the same expiration date. However, the strike price of the long put is more than the short put option . The differences in the strike prices of puts allow investors to earn returns and minimise risks. Also, the premium collected on selling a put is a gain for the investor. If the asset’s price falls marginally, you get to earn guaranteed returns. The maximum loss in this strategy is limited to the net premium paid for options.
Example of a Bear Put Spread
Let us take a bear put spread example for clear understanding. Suppose you purchased a put option based on a stock (100 shares) with a strike price of Rs 100. The stock is currently trading at Rs 98, and the investor expects a decline in the price. For the same rationale, the investor sells another put option with a strike price of Rs 95. The premium paid for purchasing the put option is Rs 200 (2 per share). The premium received for the short put is Rs 100 (1 per share).
In the above case, the short put will not be exercised when the stock’s market value is below Rs 95 on the expiration date. The maximum profit for the investor will be:
Maximum Profit = (strike price of the long put – strike price of the short put) – net premium paid
In the above example, the maximum profit based on the formula would be Rs 400 (100*100 – 100*95 – 100). The maximum loss observed in a bear put spread is the net premium paid. In the above example, the net premium paid is Rs 100, which is also the maximum possible loss.
What Does the Bear Put Spread Strategy Result In?
The bear put spread strategy results in a net debit. The maximum amount you can lose is the premium paid to acquire the long put minus the premium received for the short put. This situation is called the net debit. It helps cap potential losses from the spread of the strike prices in two puts.
The strategy is perfect when there is a marginal price movement. When the prices fall slightly, you will profit with the bear put spread. However, you won’t make anything when the prices fall significantly. However, you don’t have to worry about maximum losses, as they are already capped.
You will already know the maximum losses and gains in this strategy. It gives you the confidence you need to take positions in the market. You can also calculate the breakeven point from this strategy. You will not make any profits or encounter losses when the price levels reach the breakeven point. The formula for the upper and lower breakeven points is as follows:
Upper Breakeven Point = Strike price of the long put – premium paid (net)
Lower Breakeven Point = Strike price of the short put – premium paid (net)
Advantages and Disadvantages of a Bear Put Spread
Now that you fully understand the bear put spread strategy, let’s discuss the pros and cons. Most investors prefer this strategy to offset risks in options trading . The risk of trading options is minimised, and a loss equal to the net premium paid is encountered with this strategy. Offsetting the cost of a long put with a short put is possible in this spread. However, the short put’s strike price must be lower than that of the long put to offset costs.
This strategy uses two or more put options to minimise risks. Purchasing and selling the same number of puts to implement this strategy is recommended. It is a better approach compared to purchasing or selling puts individually. For instance, being open to unlimited risks with only a single short put can lead to significant losses if the asset’s price drops significantly.
The strategy is perfect for modestly declining markets with a small fall in value. Even with a slight price drop, the spread can make some profit. Implementing a spread strategy is relatively simple compared to other complex strategies.
Despite its popularity among investors, there are a few disadvantages. The maximum profit in this strategy is limited to the difference between the strike prices of both puts. Subtracting the net premium paid is necessary to calculate the net gain. The strategy might not work in markets experiencing significant downside movement. Profits might not be realized when the asset’s price falls or rises drastically. It’s crucial to ensure that the quantity of the underlying asset is the same in both puts and that their expiration dates align. Ignoring these basics while implementing the strategy could result in significant losses.
In a Nutshell
The bear put spread strategy can help minimise the risk of options trading. It involves purchasing and writing off the same number of puts. The expiration date for the puts must be the same. However, the short put has a lower strike than that of the long put. It helps you make a profit by creating a net debt situation. Start implementing the bear put spread strategy today!