What are Bear Put Spreads?

A bear put spread is a trading strategy in the options market where the trader purchases put options at a predetermined strike price while simultaneously selling the same number of put contracts at a strike price which is lower in value than the strike price of his earlier contract. This type of options trading strategy is used when the trader expects the price of the underlying asset being traded to drop. The trader therefore expects to profit from the difference in the price of the two put option contracts, after transaction costs have been removed.

A number of things occur in this option trade. First, the trader has to be sure that the price of the underlying asset will decline, necessitating a put option purchase. He then purchases the first contract at a certain strike price, then sells another options contract at a lower strike price, aiming to profit from the difference between the two. If for any reason the second strike price rises above the first strike price instead of falling, the trade will end up a loser. But if the price of the underlying asset drops to meet the second strike price, the trade will be a winner.

Options trades always have an expiry, so the trader must set an expiry date when he is placing this trade.

Trade Example

For this example, we will assume that the underlying asset (let’s say it is a stock) is trading at $50, and the trader wants to play the bear put spread on this trade, with four option contracts. The options trader decides to trade this by purchasing four put option contracts at a strike price of $60, for a total cost of $2000 ($5 X 100 shares/contract). Recall that the trader purchased four contracts, so this is ($5 X 400 shares) = $2000

At the same time, the trader sells four option contracts with a strike price of $50, for $800 ($2 X 100 shares/contract)

This trade will cost the trader a total of $1200 to set up this trade strategy ($2000 – $800).

If the price of this stock closes below $50 when the trade expires, the trader will make a profit of:

({$60 – $50} X 400 shares) – {$2000 – $800}) = 4000 – 1200 = $2800.

So the trader will walk away with a profit of $2,800 for this bear put spread trade.

 

 

 

Considerations

Now while this technically sound very easy, in reality it is not as there are several factors that must fall into place for the trade to be successful.

Firstly, the trader must analyse the underlying asset to determine its price direction. From our example, if the stock being traded had ended above $60 on expiration, then the trade would have been out-of-the-money.

Secondly, an appropriate expiry date/time must be set by the trader so that it allows just enough time for the asset to behave as the trader wishes, but not too much time for the asset to change its mind.

Thirdly, the trader must keep his trade size to within 5% exposure maximum in conformity with acceptable risk management practices.

If these rules are obeyed, then the trader will go home smiling with some money in the bank.

Recent Posts