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Bear Put Spreads: Everything You Should Know

A s you delve further into stock market investing, you’ll find that you run into new lingo all the time. Many of these phrases, such as bear put spread, describe specific investment strategies and techniques that you may be able to incorporate into your trading strategy. Today, we’ll take a deep dive into bear put spreads and how you can use this method to potentially increase your trading profits.

Key Takeaways

  • Bear put spreads are trading strategies designed to take advantage of the slow decline in the price of a stock or asset.
  • A bear put spread consists of one long put, or option, with one short put. These put options have different strike prices but the same expiration date and underlying asset.
  • Bear put spreads limit the investor’s maximum profit as well as his or her maximum risk.
  • A bearish market on a general decline provides the best environment for a bear put spread.
  • Time decay, volatility, and changes in the underlying stock price all affect the outcome of bear put spreads.
  • The advantages of bear put spreads include the chance to increase potential profits and reduce costs while minimizing risk.
  • Bear put spreads can result in a significant loss if you fall victim to early assignment without a plan to exit your position.
  • Understanding the indicators of a bear market will allow you to put a bear put spread strategy into action.

What Are Bear Put Spreads?

Image via Flickr by investmentzen

With a bear put spread, the investor identifies an asset with a slow, steady price decrease and tries to profit from that decline. The term ‘put’ refers to a put option. With this technique, you pay a premium price to reserve the option to sell a certain stock at a certain price (the strike price) before a certain date. As a stock price drops, the put option grows in value. ‘Spread’ refers to the difference between an asset’s lowest asking price and its highest bid price.

You may also hear a bear put spread called a debit put spread or a long put spread.

When you place a bear put spread, you make one short put and then one long put for the same underlying stock or asset and the same expiration date. The long put should have a higher strike price than the strike price you set for the short put. This type of spread is called a vertical spread.

Let’s look at an example. You think XYZ stock will decline in the coming days and weeks. The current share price is $66. You buy a $50 put option for $2 and sell a $60 put option for $4. To break even, you need XYZ stock to fall below $58 per share. The further the stock price falls, the larger your profit on this put spread.

Calculating Maximum Profit

To find the maximum possible profit from bear put spreads, subtract the lower strike price from the higher strike price, then subtract commissions and other costs of the spread. For example, if you have a put option with a $200 strike price and one with a $175 strike price, the maximum profit is $25 per share minus commissions and fees. You would receive the maximum profit from a bear put spread when the stock’s value is equal to or lower than the short put when the option expires.

Understanding Maximum Risk

With bear put spreads, you can only lose the premium cost of the spread, plus associated fees and commissions. This occurs if you hold the option until it expires and the stock price exceeds the strike price of the long put at that time, which renders both puts valueless.

Using Bear Put Spreads

This type of strategy works best in a generally bearish market. The atmosphere to profit from a bear put spread is best when the value of the underlying asset is declining as the option closes in on its expiration date.

When you establish a bear put spread for an asset, you set yourself up for one of three potential outcomes when it expires:

  • If the value of the stock falls below the lower strike price, assign the short put and exercise the long put.
  • If the value of the stock falls between the two strike prices, create a short position and exercise the long put.
  • If the value of the stock rises above the higher strike price, the option expires without value.

Factors That Influence Bear Put Spreads

Investors using these spreads should be aware of these factors that can impact their value.

Stock Price Chance

The price of a bear put spread goes up as the underlying stock goes down and rises when the price of the underlying stock falls. Traders call this concept net negative delta, where delta describes the inverse relationship between the option price and the stock price. This relationship is usually roughly proportional.

Volatility

This concept measures the amount an asset’s price fluctuates as a percentage. Assets with higher volatility tend to have higher option prices. However, the design of a bear put spread shields the deal against the impact of volatility. This type of minimal impact is known as near-zero vega in the trading world.

Time Decay

As the expiration date of an option approaches, its time value may decrease. Investors call this concept time decay or erosion. The impact of time decay on bear put spreads varies based on the difference between the strike prices and the stock price:

  • When the stock price approaches or exceeds the long put price, the option value decreases as expiration approaches as follows.
  • When the stock price approaches or drops below the short put price, the option value increases as expiration approaches.
  • Time decay is negligible when the stock price falls between the short put and long put prices.

Advantages of Bear Put Spreads

With bear put spreads, you spend less than you would to purchase only the higher strike put while increasing your chances of a higher profit percentage. This reduces your overall risk level. You can also reduce your costs if you sell the lower put. Traders can access the potential profit of short-selling a stock without the nearly unlimited possible loss associated with that strategy.

Disadvantages of Bear Put Spreads

As with any option, the person who purchases the option can be obligated to fulfill it if an early assignment occurs. This risk prevails when the underlying stock or financial asset is subject to major news, such as a dividend issue, acquisition, or merger. U.S. traders who buy an option can exercise it on any business day, requiring the option holder to immediately fulfill the obligation without the ability to control timing. You must be able to tolerate this risk to experiment with bear put spreads and other short options.

Usually, only the short put in a bear put spread carries a risk of early assignment. This may occur with a put that’s in the money with a time value below its dividend value. If this red flag occurs, you can either keep the long put open and close the short put or sell the long put and buy the short put to get out of the position unscathed.

When a short put is assigned early, you must buy the stock and either exercise your long put or resell the stock on the market. However, this could result in additional commissions and fees. An early assignment could also trigger a margin call, which means the value of your brokerage account falls below the required minimum.

Understanding bear put spreads can help you diversify your portfolio and hedge against risk. Now that you have the basics, keep an eye out for a bearish environment that’s right for this type of strategy.