Long Put Spread – ( Bear Put Spread)
The Setup
Imagine you are tracking a stock currently priced at $100 per share, anticipating a mild drop. You could set up a Bear Put Spread by:
- Buying one put option with a strike price of $100, costing you a premium of $7.
- Selling one put option with a strike price of $90, for which you receive a premium of $3.
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 purchased put with a higher strike price has a higher cost but will start gaining value as the stock begins to fall below this strike. The sold put with a lower strike price helps finance the purchase of the higher-strike put but caps the maximum profit as it obligates the seller to buy the stock if it falls below this lower strike price.
Breakeven Process
The breakeven point for a Bear Put Spread is calculated by subtracting the net premium paid from the strike price of the long put. In our example, with a $100 strike long put and a net cost of $4, the breakeven would be $96 ($100 - $4).
Sweet Spot
The sweet spot for this strategy is at or below the lower strike price ($90 in the example) at expiration. At this level, the maximum profit potential of the spread is realized.
Max Profit Potential
The maximum profit for 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 limited to the net premium paid for the spread, which is $4 per share in this example. This loss occurs if 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
Time decay, or theta, affects this strategy negatively. As expiration approaches, the value of both put options may decrease, but this will generally impact the long put more adversely than the short put, especially if the stock price remains above the higher strike price.
Implied Volatility
Changes in implied volatility can also impact this strategy. An increase in volatility tends to increase the price of both puts, potentially beneficial if it occurs before the stock price moves significantly. A decrease in volatility can reduce the value of the spread, particularly harmful if the stock price has not moved much.
Conclusion
The Bear Put Spread is a cost-effective strategy for traders expecting moderate price declines in the underlying asset. It offers a balanced approach to risk and potential return by capping both, making it a prudent choice during times of uncertainty or expected downward movement without exposure to significant risk.