Long Put Spread – ( Bear Put Spread)
The Long Put Spread, also known as a Bear Put Spread, is a simple options trading strategy that is applied when an investor expects a moderate decline in the price of the underlying asset. It involves buying a put option at a higher strike price and simultaneously selling another put option at a lower strike price, both with the same expiration date.
The Long Put Spread Setup
Imagine you track a stock whose price is quoted at $100 per share with a mild projection of decline. You can place a Bear Put Spread by:
- Buying one put option whose strike price would be $100, which means you will be paying a premium of $7.
- Selling one put option whose strike price would be $90, so you get $3 as your premium.
This creates a net debit (cost) of $4 ($7 paid - $3 received), which is the most you can lose in this setup.
Who Should Consider It
This strategy is suitable for traders who are moderately bearish on a stock or an index. It’s particularly appealing for those who want to limit their risk while having a clear idea of the maximum potential loss and profit right from the start.
Strategy Explained
In a Bear Put Spread, the higher strike price put purchased is more expensive but will begin to rise in value as the stock falls below this strike. The lower strike price sold put finances the purchase of the higher-strike put but limits the maximum profit as it obligates the seller to buy the stock if it falls below this lower strike price.
Breakeven Process
To calculate the breakeven point for a Bear Put Spread, subtract the net premium paid from the strike price of the long put. For our example, with a $100 strike long put and a net cost of $4, the breakeven would be $96 ($100 - $4).
Sweet Spot
This strategy’s sweet spot is at or below the lower strike price ($90 in the example) at expiration. The maximum profit potential of this spread is realized here.
Max Profit Potential
The maximum profit of a Bear Put Spread is the difference between the strike prices minus the net premium paid. For the example, the maximum profit would be $6 per share ($10 difference between strikes - $4 net premium paid).
Max Loss
The maximum loss is capped at the net premium paid for the spread, which in this example is $4 per share. This loss happens when the stock price is at or above the higher strike price at expiration.
Risk
The primary risk is the stock price finishing above the breakeven point at expiration, leading to a total loss of the premium paid. However, this risk is lower than buying a single put option outright due to the premium received from selling the lower-strike put.
Time Decay
Theta, or time decay, negatively impacts this strategy. With expiry approaching, the value of each put may decrease, but typically this decreases the long put’s value more than the short put, especially where stock price stays above the higher strike.
Implied volatility will also have some impact on the strategy. This tends to positively impact both prices if the move is made up before much in stock price changes. Decline in volatility means the spread decreases in value which can be most damaging when no stock price action has been done.
The Bear Put Spread is the cheapest strategy a trader can take when expecting the underlying asset to drop moderately in price. This is because the strategy caps both risk and potential return, thereby being prudent at uncertain times or when expecting downward movement without high risk exposure.