A Strategy For Profiting Even When A Stock Is Headed South

When you establish a bear put spread, you purchase a put option on a particular underlying stock, while writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This type of spread is sometimes more broadly referred to as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. You can create a spread with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. For this bearish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded.

Market Opinion

Moderately Bearish to Bearish

When to Use

You often employ the bear put spread in moderately bearish market environments where you want to capitalize on a modest decrease in price of the underlying stock. If your opinion is very bearish on a stock, you could consider making a simple put purchase.

Risk Reduction

Choosing a spread helps when you're uncomfortable with either the cost of purchasing and holding the long put alone, or that your bearish market opinion will hold.

Benefit

A bear put spread can be considered a doubly hedged strategy. The price paid for the put with the higher strike price is partially offset by the premium received from writing the put with a lower strike price. In other words, your investment in the long put and the risk of losing the entire premium paid for it, is reduced or hedged.

It should also be noted, the long put with the higher strike price caps or hedges your financial risk of the written put with the lower strike price. If you are assigned an exercise notice on the written put, and have to purchase an equivalent number of underlying shares at the put's strike price, you can sell the purchased put with the higher strike price in the marketplace. The premium received from the put's sale can partially offset your cost of purchasing the shares from the assignment. The net cost to you will generally be a price less than current market prices. The trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy.

Risk vs. Reward

Downside Maximum Profit: Limited
Difference Between Strike Prices - Net Debit Paid

Maximum Loss: Limited
Net Debit Paid

If the underlying stock decreases in price, a bear put spread tends to be profitable. It can be established in one transaction, but always at a debit (net cash outflow). The put with the higher strike price will always be purchased at a price greater than the offsetting premium received from writing the put with the lower strike price.

Maximum loss for this spread will generally occur as underlying stock price rises above the higher strike price. If both options expire out-of-the-money with no value, your entire net debit you paid for the spread will be lost.

Your maximum profit for a spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money. This will be the case no matter how low the underlying stock has declined in price. If the underlying stock is in between the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its intrinsic value. The written put will be out-of-the-money, and have no value.

Break-Even-Point

Strike Price of Purchased Put - Net Debit Paid

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in either the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the written put, profits generally increase at a faster rate as time passes.

Alternatives before expiration

A bear put spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. Generally this is how investors close out a spread before its options expire, in order to cut a loss or realize profit.

Alternatives at expiration

If both options have value, you will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the puts.

If only the purchased put is in-the-money and has value as it expires, the you can sell it in the market place before the close of the market on the option's last trading day. Or, you can exercise the put and either sell an equivalent number of shares you own or establish a short stock position.