For our Bearish Spread, let's say, we were observing the Amati Communications, symbol AMTX for some time and we have some good fundamental reasons to believe that the stock is overpriced. Assuming you already know the Bearish Spread technique, you can take advantage of this anticipation.

At that point, we decide to buy a Bearish Spread of Amati Communication at a current stock price of $ 14.50 a share. Our Bearish Spread will consist of two put options. We buy the put option with an exercise price of $15.00 for $1.25 and we sell the put option with an exercise price of 12.50 for $0.25.

IT IS JANUARY. WE DECIDE TO BUY THE PUT FOR $1.25 AND SELL THE PUT FOR $0.25 FOR THE FEBRUARY EXPIRATION DATE. 

EXPIRATION DATES: are always the third Friday of each month!

STRIKE PRICE: Is the price at which the underlying stock will be sold if the buyer of the option exercises the purchase.

PREMIUM: Is how much you pay when you buy an option or how much you receive if you sell it.

CONTRACTS: options are always written in 100 shares: one contract =100 shares

As we purchase a Bearish Spread on AMTX for 300 shares,this is equal to buying 3 put contracts for a $15.00 strike price and to selling 3 put contracts for a $12.50 strike price at February expiration date.

YOU HAVE TO SPEND

300 shares x $1.25 = $375.00 For buying 3 put contracts
Minus 300 shares x $0.25 = $75.00 For selling 3 put contracts

Total paid for Bearish Spread = $300.00

REMEMBER: THE STRATEGY IS NOT TO EXERCISE YOUR BEARISH SPREAD BUT TO SELL IT BEFORE THE EXPIRATION DATE, AS SOON AS IT HAS REACHED A GAIN THAT YOU ARE SATISFIED WITH. AS A RULE OF THUMB, PROFIT WILL BE MORE SUBSTANTIAL BY SELLING THE BEARISH SPREAD YOUR BOUGHT THAN EXERCISING IT. YOUR BROKER WILL HANDLE THE TRANSACTION AFTER NOTIFICATION. HOWEVER, FOR PURPOSES OF SIMPLIFICATION WE WILL USE THE SCENARIO WHERE THE BEARISH SPREAD IS EXERCISED.

Return Example 1

If from the time we bought the Bearish Spread until its expiration date the STOCK PRICE OF AMTX WENT DOWN FROM $14.50 TO $12.50 we can exercise the put option that we own with $15.00 strike price or sell it. The put option with $12.50 strike price that we sold expires worthless. The cash flow of this transaction is as follows: you paid $1.00 per share for this Bearish Spread ($1.25 for $15.00 put, minus $0.25 that you received for selling $12.50 put). As the strike price is $15.00 and the stock price is at $12.50 we have $2.50 difference -$1.00 invested =$1.50 per share. A 150% profit. For purposes of simplification commissions are not included.

Return Example 2

If from the time we bought the Bearish Spread until its expiration date the STOCK PRICE OF AMTX WENT DOWN FROM $14.50 TO $11.50 we can exercise the put option that we own with $15.00 strike price or sell it. The put option with $12.50 strike price that we sold will be also exercised. The cash flow of this transaction is as follows: you paid $1.00 per share for this Bearish Spread ($1.25 for $15.00 put, minus $0.25 that you received for selling $12.50 put). As the strike price is $15.00 and the stock price is at $11.50 we have $3.50 difference -$1.00 invested - $1.00 (we have to pay to the owner of the put option with strike price of $12.50 that we sold) =$1.50 per share. A 150% profit. For purposes of simplification commissions are not included.

As you have noticed regardless how much the price drops you can't make more than a certain amount. That is the price you pay for limited risk.

As we see, by buying a Bearish Spread you benefit if the stock declines in value by more that what you paid for it. In our case, the stock price has to move lower than $14.00.Now what happens if stock stays above $14.00? Unfortunately, we are losing some money. The higher the stock value the more we lose.

Why Not Buy A Naked Put?

1. You pay more for the Naked Put. In our case you pay $1.00 for the Bearish Spread. The Naked Put, as you recall, cost 25% more or $1.25. 

2. You need your stock to move more in order for a trade to become profitable. In our case if you buy a Bearish Spread you make money if the stock declines more than $1.00. If you have a Naked Put you need your stock to move more than $1.25 to make money.

3. Last but not least, if you are wrong you lose more than if you buy a Naked Put. In this case you loose 25% more.

Now, having learned the process involved in buying Bearish Spreads we need to emphasize what factors are important to watch.

As you can see, investing in Bearish Spreads can be a great tool to make money even if you think that the stock price will decline.