Bear put spread

  • The Options Institute at CBOE®

Goal

To profit from a gradual price decline in the underlying stock.

Explanation

Example of bear put spread

Buy 1 XYZ 100 put at (3.20)
Sell 1 XYZ 95 put at 1.30
Net cost = (1.90)

A bear put spread consists of one long put with a higher strike price and one short put with a lower strike price. Both puts have the same underlying stock and the same expiration date. A bear put spread is established for a net debit (or net cost) and profits as the underlying stock declines in price. Profit is limited if the stock price falls below the strike price of the short put lower strike), and potential loss is limited if the stock price rises above the strike price of the long put (higher strike).

Maximum profit

Potential profit is limited to the difference between the strike prices minus the net cost of the spread including commissions. In the example above, the difference between the strike prices is 5.00 (100.00 – 95.00 = 5.00), and the net cost of the spread is 1.90 (3.20 – 1.30 = 1.90). The maximum profit, therefore, is 3.10 (5.00 – 1.90 = 3.10) per share less commissions. This maximum profit is realized if the stock price is at or below the strike price of the short put (lower strike) at expiration. Short puts are generally assigned at expiration when the stock price is below the strike price. However, there is a possibility of early assignment. See below.

Maximum risk

The maximum risk is equal to the cost of the spread including commissions. A loss of this amount is realized if the position is held to expiration and both puts expire worthless. Both puts will expire worthless if the stock price at expiration is above the strike price of the long put (higher strike).

Breakeven stock price at expiration

Strike price of long put (higher strike) minus net premium paid

In this example: 100.00 − 1.90 = 98.10

Profit/Loss diagram and table:

Buy 1 XYZ 100 put at (3.20)
Sell 1 XYZ 95 put at 1.30
Net cost = (1.90)
Stock Price at Expiration Long 100 Put Profit/(Loss) at Expiration Short 95 Put Profit/(Loss) at Expiration Bear Put Spread Profit/(Loss) at Expiration
104 (3.20) +1.30 (1.90)
103 (3.20) +1.30 (1.90)
102 (3.20) +1.30 (1.90)
101 (3.20) +1.30 (1.90)
100 (3.20) +1.30 (1.90)
99 (2.20) +1.30 (0.90)
98 (1.20) +1.30 +0.10
97 (0.20) +1.30 +1.10
96 +0.80 +1.30 +2.10
95 +1.80 +1.30 +3.10
94 +2.80 +0.30 +3.10
93 +3.80 (0.70) +3.10
92 +4.80 (1.70) +3.10

Appropriate market forecast

A bear put spread performs best when the price of the underlying stock falls below the strike price of the short put at expiration. Therefore, the ideal forecast is “modestly bearish.”

Strategy discussion

Bear put spreads have limited profit potential, but they cost less than buying only the higher strike put. Since most stock price changes are “small,” bear put spreads, in theory, have a greater chance of making a larger percentage profit than buying only the higher strike put. In practice, however, choosing a bear put spread instead of buying only the higher strike put is a subjective decision. Bear put spreads benefit from two factors, a falling stock price and time decay of the short option. A bear put spread is the strategy of choice when the forecast is for a gradual price decline to the strike price of the short put.

Impact of stock price change

A bear put spread rises in price as the stock price falls and declines in price as the stock price rises. This means that the position has a “net negative delta.” Delta estimates how much an option price will change as the stock price changes, and the change in option price is generally less than dollar-for-dollar with the change in stock price. Also, because a bear put spread consists of one long put and one short put, the net delta changes very little as the stock price changes and time to expiration is unchanged. In the language of options, this is a “near-zero gamma.” Gamma estimates how much the delta of a position changes as the stock price changes.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bear put spread consists of one long put and one short put, the price of a bear put spread changes very little when volatility changes. In the language of options, this is a “near-zero vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since a bear put spread consists of one long put and one short put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or above the strike price of the long put (higher strike price), then the price of the bear put spread decreases with passing of time (and loses money). This happens because the long put is closest to the money and decreases in value faster than the short put. However, if the stock price is “close to” or below the strike price of the short put (lower strike price), then the price of the bear put spread increases with passing time (and makes money). This happens because the short put is now closer to the money and decreases in value faster than the long put. If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bear put spread, because both the long put and the short put decay at approximately the same rate.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put in a bear put spread has no risk of early assignment, the short put does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bear put spread (the lower strike price), an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways. First, the entire spread can be closed by selling the long put to close and buying the short put to close. Alternatively, the short put can be purchased to close and the long put can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put. Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at or above the higher strike price, below the higher strike price but not below the lower strike price or below the lower strike price. If the stock price is at or above the higher strike price, then both puts in a bear put spread expire worthless and no stock position is created. If the stock price is below the higher strike price but not below the lower strike price, then the long put is exercised and a short stock position is created. If the stock price is below the lower strike price, then the long put is exercised and the short put is assigned. The result is that stock is sold at the higher strike price and purchased at the lower strike price and no stock position is created.

Other considerations

The “bear put spread” strategy has other names. It is also known as a “debit put spread” and as a “long put spread.” The term “bear” refers to the fact that the strategy profits with bearish, or falling, stock prices. The term “debit” refers to the fact that the strategy is created for a net cost, or net debit. Finally, the term “long” refers to the fact that this strategy is “purchased,” which is another way of saying that it is created for a net cost.