Bear Put Spread(Long Put spread)

The Bear Put Spread Setup

Imagine for a moment that you are watching ABC Corp, which is now selling at $150 per share. Expecting moderate downwards movement, you set up a bear put spread by buying a put option with a $150 strike for $10 and selling a put option with a $140 strike for $5. Both options expire in three months.

Who can get into it

This strategy is best suited to investors expecting no more than moderate weakness in the underlying stock price. These options are also suitable for limiting possible losses while controlling the cost of an outright bearish entry.

How It Works

By purchasing a put option with a higher strike price and selling one with a lower strike price, you put a cap on your maximum gain to the difference between the two strike prices minus the net cost of the options. The premium received from the sale of the lower strike put decreases the overall cost of taking a bearish view.

Breakeven Analysis

The breakeven for a bear put spread is the higher strike less the net cost of the spread. In our example on ABC, the net cost came to $5 ($10 paid and $5 received), leading to our breakeven point at $145 ($150 strike price-$5 net cost).

Sweet Spot

The ideal situation for this strategy is when the stock price comes close to or is below the lower strike price at expiration. This scenario gives the most extensive spread value and equals the maximum profit potential.

Max-Profit Potential

The maximum profit for a bear put spread is the strike width minus the net premium for the position. In this case, $5 profit should be expected ($150 - $140 - $5).

Maximum Loss

The maximum loss is the net premium paid to establish the spread, limited to $5 per share in this case. The maximum loss occurs when the stock price is above or at the higher strike price at expiration.

Risk

The singular risk is for the stock price to end above the breakeven point at expiration, ripping the investor of the entire premium paid and unable to cover their positions. However, it poses less risk than having to buy just a normal put option since the investor gets a premium from selling the lower strike put.

Time Decay

Time decay, or theta, where the time decay effects of the two positions offset each other, is an important factor in this strategy. In the event that the price trend is more favorable and the expiration comes soon enough, it can create an advantage for the trader if the stock is trading nearer to the lower strike.

Implied Volatility

Implied volatility has a much varied impact on this strategy. Generally, an increase in volatility benefits the long put more than it hinders the short put, particularly if the stock price is around or above the higher strike. Conversely, lower volatility generally favors this position nearing expiration if the stock price is around the lower strike.

Conclusion

The bear put spread represents a sound investment choice for traders expecting a gradual price decline in the underlying action. This technique provides a mixture of acceptable risk and a measured potential for return through limited risk and reward on either end of its differential position. This strategy seems especially appealing during periods of high option premiums, in that the cost of direct bearish plays may be offset by the premiums collected on short puts.