Introduction to the Bear Put Spread

A bear put spread is the simultaneous purchasing and writing of two put options. This spread has the advantage of lowering the cost of the initial investment as well as defining a set maximum loss and maximum profit amount. Compared to buying only one put, which could lose and gain value dramatically overnight, a bear put spread also provides greater price stability throughout the life of the spread.

For example, let’s say you are bearish on the major S&P 500 index, and it is trading around 1150. A bear put spread would be the buying of the lower exercise price put and the writing of the higher exercise price put, which could be 1050 and 1150. If the cost of the spread is $5,000, that will be the maximum loss amount, where the maximum profit would be the difference between the two exercise prices (1150 - 1050 = 100 points). If every point is valued at $50, the maximum profit in dollars is $5,000 (100 x $50). The goal for you, the investor, is to find the S&P 500 reach 1050 or lower at the expiration date in order to maximize the profit on the bear put spread.

In the meantime, since time has a lot to do with options value, the markets may go in your favor, but there may be a lot of time until exercise still left with the options. This scenario is undesirable because the markets have moved in your favor, yet you cannot be fully rewarded with the bear put spread if there is a lot of time left before exercise.

With bear put spreads (as well as with bull call spreads, which are the same idea but used for the opposite market direction), either the market is to your advantage or time is--but both are never in your favor.

Therefore, when executed correctly, the bear put spread is a medium term strategy (4 months to a year until exercise) that speculates a delayed drop in the market. In other words, if there is speculation of an imminent decline within a month or less, it would be best to simply buy a put rather than execute the bear put spread.

If you have experience with options, then you know there are many factors in considering the price of options and what to expect in owning that investment. If you are not familiar with options, these are the main factors to consider:

  • Exercise price
  • Time until exercise
  • Volatility

The exercise price for a put option is the price at which the option holder has the right to sell the stock or investment. Time until exercise is the time you have for the option to retain its value, since options are depreciating assets with a set exercise date. Volatility is the daily swings in the price of the underlying investment. The greater the volatility, the more premium or higher price you will pay for the option, and vice versa.

blog comments powered by Disqus
Scottrade