Bear Put Spread

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What is Bear Put Spread?

Bear put spread is a derivatives strategy that is usually implemented when the market outlook is slightly bearish and expectations of moderate fall are there and involves buying a nearby strike put option or an in-the-money (ITM) put option and selling a far-off strike put option or an out-of-money (OTM) put option.

Bear put spread strategy provides good gains if the underlying moves as expected by the trader or investor at the inception; however, if in case the underlying moves contrary to the expectations of the trader or investor, the loss is limited to the net premium paid (difference of the premium paid on buying the nearby strike put option and premium received on selling the far-off strike put option).

What is Bear Put Spread?

. The bear put spread is a derivatives strategy for a slightly bearish market outlook. It involves buying a set option with a nearby or in-the-money strike price and selling it with a faraway or out-of-the-money strike price.
Potential profit is possible if the asset moves as expected. Losses are limited to the net premium paid - the difference between the nearby and far-off strike put option premiums.
The selling of an out-of-the-money put option limits potential profit. If the underlying asset rises, you lose the net premium. This approach only works for negative outlooks.

Bear Put Spread Explained

Beat put spread refers to an options trading strategy. This strategy is deployed when the trader is betting on the price of the security to experience a moderate or sharp decline. Therefore, they look to reduce the cost or losses of holding the asset in a downward trend.

Professional traders frequently use the Bear put spread calculator in a moderately bearish outlook to generate moderate gains. The strategy is a low-cost, effective tool used even for hedging purposes. It is up to the trader/investor to determine the right strike prices and consider the implied volatility of the underlying to make better choices.

However, it is important to keep in mind that both the option purchased and sold should be of the same expiry. Although, the net premium amount paid is the maximum loss incurred in case the outlook fails; however, selling an option requires the keeping of a lot of margins, and the cost of funds of such margin needs to be accounted for while opting for such a strategy.

Formula

Let us understand the formula for incorporating the bear put spread strategy. This formula acts as the basis for the calculations and strategies inculcated by traders and fund managers.

Max(0,X2- ST)-Max(0,X1- ST) + P1- P2

Where,

X1= Far off strike price of put option sold
X2= Nearby strike price of put option purchased
ST= Closing price of underlying stock/index on expiry
P1= Premium received on selling the far off strike put option
P2= Premium paid on buying the nearby strike put option

Bear Put Spread Payoff

Let us understand the payoff diagram concerning bear put spreads.

The Y axis of the following graph denotes the option position’s overall profit or loss based on the price of the underlying asset, represented by the axis.

Suppose Sam, a trader using the bear put spread strategy purchased a strike put worth $275 and sold a strike put of $320 for a net $0.80 for each contract (or $80 for every standard option contract denoting 100 shares).

Note that the premium of $80 is the maximum amount Sam’s trade can lose. It materializes when the underlying asset price is $275 and higher.

At the time of expiry, the maximum profit is earned below $320, while the lines cross into gains at a specific point after the price of the asset drops under the breakeven point.

One can compute the breakeven point by finding the difference between the strike price and the premium paid.

Thus, in this case, the breakeven point will be as follows:

Breakeven Point = 275 – 0.80, i.e., 274. 2

Examples

Let us understand how traders use the bear put spread calculator to hedge their risks and limit the cost of holding the asset with the help of a couple of examples.

Example #1

Klain International has a moderately Bearish outlook on European markets and decided to enter into a bear put spread on the NIFTY INDEX to benefit from the outlook on 01.11.2019.

The nifty index spot level as of 01.11.2019 is 12000.
The price of nifty 12000PE expiring on 27.11.2019 (monthly expiry) is $140
The price of nifty 11800PE expiring on 27.11.2019 (monthly expiry) is $70
The lot size is 100 units.

This is entered by:

Buying one lot of nifty 12000PE for $140 (Total Cost= $140*100=$14000)
Selling one lot of nifty 11800PE for $70 (Total Cost= $70*100=$7000)
Net premium paid= $14000-$7000=$7000

The maximum profit under this spread is equivalent to $13000 (100*$130). Under this maximum loss to Klain International is limited to the net premium paid, i.e., $7000. The Break-even point under the bear put spread is the 11930 nifty index spot level.

It reaches maximum profit when the underlying security reaches the far-off strike price put option, which in our case was 11800. And below this level, the profit will not maximize. Similarly, profit will increase between the two strike prices, i.e., 12000 and 11800, and the maximum loss will be equivalent to the net premium paid.

Example #2

In November 2022, the Equity Traded Fund (ETF) iShares US Real Estate ETF (IYR) dropped below its 50-day moving average. However, market experts believed that the stock could net $425 using the bear put spread.

If a trader marks 82 as the long put and targets 77 strikes as the short put, with an expiration date of January 20, 2023, the stock would have to decline roughly 9%. It would cost $75 for each contract with maximum potential earnings of $425.

If the ETF is trading above the 82 mark, then the option would become null and void or stand a chance to gain $75 for a 100-share contract.

Advantages

Let us understand the advantages of a trader using bear put spread calculator through the points below.

It is a low-cost, limited-risk options strategy that benefits when the Market outlook is moderately bearish.
The strategy benefits even in small price falls and doesn’t require a big fall to generate returns.

Disadvantages

Let us also understand the other end of the spectrum by discussing the disadvantages of incorporating the bear put spread strategy through the explanation below.

It only results in a small profit as the upside is capped due to selling an out-of-money put option.
If the underlying asset rises, it results in a loss of the entire net premium.
The spread strategy works only when the outlook is bearish.

Bear Put Spread Vs Bear Call Spread

Both the bear put spread strategy and the bear call spread strategy, have been popular among professional traders and fund managers mainly because their performances are gauged based on absolute returns and not relative returns. However, there are differences in their fundamentals and implications. Let us understand them through the comparison below.

Particulars	Bear Put Spread	Bear Call Spread
Definition	This involves buying a higher exercise price put or an In-the-money (ITM) put and selling a lower exercise price put or an out-of-money (OTM) put.	Bear call spread involves selling a call with a low exercise price or an In-the-money call and buying a call with a far-off exercise price or an out-of-money (OTM) Call.
Market/Underlying Outlook	Moderately Bearish	Moderately Bearish
Maximum loss	The maximum loss is equal to the net premium paid.	Maximum loss is equal to the spread minus net premium credited.
Inflow/Outflow of Premium	It results in net premium outflow at inception.	The bear call spread results in net premium inflow at inception.
Suitability	Bear put spread strategy makes more sense when the market has fallen substantially, and volatility is favorable input writing, and further fall seems moderate.	The bear call spread strategy made more sense when markets increased substantially, and volatility is favorable in call writing due to huge call premiums and expectation of the market consolidating or falling marginally.

Frequently Asked Questions (FAQs)

When to use bear put spread?

A bear put spread performs best when the underlying stock's price falls below the short put's strike price at expiration. Therefore, the ideal forecast is "modestly bearish."

What happens when a bear put spread expires?

If the position is kept until expiration and both puts expire without value, a loss of this magnitude will be incurred. It will occur when the stock price at the end is higher than the long put's strike price (which is the higher strike).

Do I need to close a bear put spread?

One can close a bear put debit spread before it expires. To exit a bear put debit spread, you must sell the long put option and buy the short put option. If you sell the spread for more than what you bought it for, you will make a profit.