This is the part 3 explanation of the 4 Vertical Spread options strategies where I will explain more in-depth about another vertical spread strategy for bearish play, which is the Bear PUT Spread Strategy. This is also known as PUT Debit spread as the options buyer will pay a premium (debit) in order to open up the spread position. The premium paid is also the maximum loss for the options contract buyer.
The 4 vertical spread strategies are summarised below:
A bear put spread in an options strategy that consists of buying a put with a higher strike price and selling a 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.
In the previous article, I mentioned that a bearish strategy of using PUT Options is to buy PUT options and thus in this Bear PUT Spread, buying PUT is predominant, which will result in net debit paid up front when the contract is established. In order to have net debit, the premium paid is higher than the premium paid.
Link to the previous article:
Vertical Spreads Options Strategies Explained For Newbies | A Simple Way To Understand And Remember Vertical Spreads
Using the direct correlation between PUT options premium and strike price, i.e. higher strike price = higher premium and vice-versa, the buy PUT leg will be at a higher strike price (higher premium) than the sell PUT leg (lower premium), to fulfill the condition of debit paid up front.
As such, the buy PUT will happen at a higher SP while the sell PUT will happen at a lower SP, as summarized below:
I hope this helps in your understanding and remembering of the Bear PUT Spread. This is a powerful strategy that you can use to short the market when the market is crashing or there is an obvious downtrend, while avoiding the higher premiums of buying PUT contracts.
What Is The Max Gain, Loss & Breakeven?
The maximum loss of a Bear PUT Spread is the premium that you pay when you open up the contract. This happens when both contracts expire OTM and become worthless.
The Maximum gain of a Bear PUT Spread is the difference of the strike price multiplied by 100 per contract, minus the premium you receive for the contract.
Max Gain = (Difference in SP x 100) – premium paid for contract
This is when both contracts expire ITM, thus you have to sell the shares at the higher price and buy the shares at the lower price.
The Breakeven Price is the higher SP – the premium price per share.
Bear PUT Spread Example
As an example, let’s say that Levi Strauss & Co. (LEVI) is trading at $50. Winter is coming, and you don’t think the jeans maker’s stock is going to thrive. Instead, you think it’s going to be mildly depressed.
So you buy a $40 put, priced at $4, and sell a $30 put, priced at $1. Both contracts will expire on 30 days later. Buying the $40 put while simultaneously selling the $30 put would cost you $3 ($4 – $1).
If the stock closed above $40 on expiration date, your maximum loss would be $3.
If it closed under or at $30, however, your maximum gain would be $10 on paper, but you have to deduct the $3 for the other trade and any broker commission fees.
The break-even price is $37—a price equal to the higher strike price minus the net debt of the trade.
Advantages of a Bull Put Spread
1. The benefit of a bear put spread is that the trader reduces the cost of the trade. If the trader doesn’t expect the price of the asset to drop much below the put option that was sold, this strategy is better than simply buying a put option.
2. A second advantage is that the breakeven price also rises. As a result of setting up a bear put spread instead of only buying a put option, the trader reduces the dollar risk if the trade goes against them — and also increases their probability of profit
Disadvantages of a Bull Put Spread
1. The downside of a bear put spread is that there’s limited profit potential as compared to buying a put option. The potential is limited to the difference between the two strikes minus the premium paid. If a trader is expecting a black swan or a capitulation event, it’s preferable to simply buy a put option, as prices may fall far below any support levels.
2. Time decay (or Theta) works against the bear put spread. This means a bear put spread has a negative Theta (loses money with time decay). The longer the option contract drags without in the desired direction, the higher the drop in premium for the option buyer. Thus, the option buyer may suffer a loss even if the share price stays stagnant or has dropped slightly.
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