When the stock market is falling, some active investors may want to try to profit from the drop. But for some situations, simply shorting a stock or buying a put may seem too risky. In that case, the options strategy called the bear put spread may fit the bill. To use this strategy, you buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital. Let's take a closer look.
Understanding the bear put spread
Although more complex than simply buying a put, the bear put spread can help to minimize risk. Why? Because you are hedging your position by buying one put option and selling another put option, which can reduce losses but can also limit your potential profits. And, this strategy involves less capital than simply buying a put.
Due to the fact that you are paying out money to initiate this strategy, it's called a debit spread. Your goal is to sell the combined position at a price that exceeds the overall purchase price, and thus make a profit.
One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. In fact, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance.
The nuts and bolts of a bear put spread
Normally, you will use the bear put spread if you are moderately bearish on a stock or other security. Your goal is for the underlying stock to drop low enough so that both options in the spread are in the money when expiration arrives, that is, the stock is below the strike price of both puts. You want the stock to fall far enough to earn more than the cost of the spread. Here is one example of how it works:
Buy a put below the market price: You will make money (after commissions) if the market price of the stock falls below your breakeven price for the strategy.
Sell a put at an even lower price: You keep the proceeds of the sale—offsetting some of the cost of the put and taking some risk off the table. You also give up any profits beyond the lower strike price.
The best-case scenario: The stock price falls as you anticipated and both puts are in the money at expiration.
Before you initiate the trade—what to look for:
Before you initiate a bear put spread, it's important to have an idea of your criteria. Here are some general guidelines.
- Underlying stock: First, you need to choose an underlying stock that you feel is likely to fall in price.
- Expiration date: Choose an options expiration date that matches your expectation for the stock price to fall.
- Strike price: Next, you must decide which strike prices to choose. For example, you may choose to buy the 45 put and sell the 40, or buy the 60 put and sell the 50. The larger the spread, the greater the profit potential, but the difference in premiums might leave you with more risk.
- Volatility: Many traders prefer to initiate the bear put spread to help offset volatility or the cost of an option. Volatility is an important factor that will affect options price.
A bear put trade
Now that you have a basic idea of how this strategy works, let's look at more specific examples of this strategy.
Note: Before placing a spread with Fidelity, you must fill out an options agreement and be approved for Level 3 options trading. Contact your Fidelity representative if you have questions.
- In June, you believe that XYZ, which is currently at $31 per share, will fall below $30 per share over the next two or three months. You decide to initiate a bear put spread.
- You buy 1 XYZ October 30 put (long put) for $3.80 per share, paying out $380 ($3.80 x 100). At the same time, you sell 1 XYZ October 25 put (short put) for $1.60 per share, receiving $160 ($1.60 x 100). Note: In this example, the strike prices of both the short put and long put are out of the money.
- Cost: Your total cost, or debit, for this trade is $220 ($380 – $160), plus commissions and fees. To initiate this trade you can place them as one trade by using the multi-leg option ticket.
- Maximum possible gain: The most you can gain from this trade is $280. To determine your maximum reward, subtract the net debit ($2.20 x 100) from the difference in strike prices ($5 x 100). In this example, it will be $280 ($500 – $220).
- Maximum risk: The most you can lose on this trade is the initial debt paid, or $220.
Let's take a look at what could go right (or wrong) with this strategy:
Example One: The underlying stock, XYZ, falls below the 30 strike price before the expiration date.
If the underlying stock falls below $30 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value. For example, the long put may rise from $3.80 to $5.70, while the short put may rise from $1.60 to $2.10. Note: Near expiration, as the long put option goes further in the money, the spread between the two put options widens, but it never surpasses that $5 maximum value.
How to close a winning trade
Before expiration, you can close both legs of the trade. In the above example, if you enter a limit order, you buy back (buy to close) the short put for $210, and sell (sell to close) the long put for $570. Your profit is $140: Sale price of $360 ($570 less $210) minus $220 (your original payment).
Example Two: The underlying stock, XYZ, remains above the 30 strike price before or near the expiration date.
If the underlying stock remains above $30 before expiration, both legs of the spread drop in value, which is not what you hoped to see. For example, the long put might fall from $3.80 to $2.10, while the short put may drop from $1.60 to $1.20.
To avoid complications, you may want to close both legs of a losing spread before the expiration date, especially if you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $220 investment.
How to close a losing trade
Before expiration, close both legs of the trade. You will buy back (buy to close) the short put for $120, and sell (sell to close) the long put for $210. In this example, your loss is $130: ($210 – $120) – $220 (your initial payment).
Although it's unlikely, there's always a chance you'll be assigned early (before expiration) on the short put. If this occurs, you may want to exercise the long put (but you may want to call Fidelity for assistance).
Other factors to consider
Trading spreads can involve a number of unforeseen events that can dramatically influence your options trades. It can help if you learn about time decay and implied volatility, and how they can affect your trade decisions.