Bear Put Spread
Establishing a bear put spread involves the purchase of a
put option on a particular underlying stock, while
simultaneously 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 spread is sometimes more
broadly categorized as a "vertical spread": a family
of spreads involving options of the same stock, same
expiration month, but different strike prices. They can
be created 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.
P/L Profile
Market Opinion?
Moderately Bearish to Bearish
When to Use?
Moderately Bearish
An investor often employs the bear put spread in moderately
bearish market environments, and wants to capitalize on a
modest decrease in price of the underlying stock. If the
investor's opinion is very bearish on a stock it will generally
prove more profitable to make a simple put purchase.
Risk Reduction
An investor will also turn to this spread when there is
discomfort with either the cost of purchasing and holding
the long put alone, or with the conviction of his bearish
market opinion.
Benefit
The 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. Thus, the investor's investment in
the long put and the risk of losing the entire premium paid
for it, is reduced or hedged.
On the other hand, the long put with the higher strike price caps
or hedges the financial risk of the written put with the lower
strike price. If the investor is assigned an exercise notice on
the written put, and must purchase an equivalent number of
underlying shares at its strike price, he can sell the purchased
put with the higher strike price in the marketplace. The premium
received from the put's sale can partially offset the cost of
purchasing the shares from the assignment. The net cost to the
investor will generally be a price less than current market prices.
As a 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
A bear put spread tends to be profitable if the underlying stock
decreases in price. 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, the entire net debit paid
for the spread will be lost.
The maximum profit for this 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 (BEP)?
BEP: 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.
This is generally the manner in which 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, investors 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 investor can sell it in the market place
before the close of the market on the option's last trading
day. On the other hand, the investor can exercise the put
and either sell an equivalent number of shares that he owns
or establish a short stock position
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