Bear put spreads are also known as put debit spreads. They are a bearish options trading strategy that involves buying a put then selling another put out of the money with the same expiration date. This combination process lowers the break even price on the trade.
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What Are Bear Put Spreads?
Bear put spreads are a bearish options strategy that limits your trading risk. It consists of buying a long put and short put strike with the same expiration date. The short put reduces the theta and delta of your contract. Buy a put and sell a put.
Who doesn’t want to learn a strategy that both maximizes profit while limiting risk? Many times we’re fighting with our emotions and trying to make home run trades. Therefore, we end up giving back our profits plus some. As a result, learning to trade this strategy is a smart way to protect your brokerage account. Watch our video to learn more.
Have you been dreaming about making a few extra dollars in the stock market yet you don’t have $1,000’s of dollars to get started? Are you looking for a way to protect yet make money at the same time?
I have exciting news; trading option spreads might be the solution for you. Today I want to talk about one spread in particular.
It’s lean, it’s mean, and it won’t break the bank. It’s the bear put spread. So hold on, and I’ll show you can profit from this money making strategy.
If you haven’t already noticed, options spreads have many different names yet mean the same thing. Take a bear put spread for example; it’s also known as long put spread, and a debit put spread.
This is because you take a debit to enter the trade. It’s important to remember that a bear put spread is vertical spread.
The End Goal
Your end goal is to buy a put hoping the price declines while at the same time writing another put. Both with the same expiration, but with a lower strike price, as a way to offset some of the cost.
Use a bear put spread when you think the price of the underlying asset will go down shortly. To build a bear put spreads, you buy a higher striking in-the-money put option and sell a lower striking out-of-the-money put option.
It’s important to remember both options are on the same underlying security with the same expiration date. Check out our service if you want to learn more about options spreads.
How to Trade Bear Put Spreads
- Buy 1 In The Money Put
- Sell 1 Out Of The Money Put
You need a net cash outlay (net debit) at the beginning due to the way you select the strike prices. Assuming the stock prices moves down toward the lower strike price (what you want) the bear put spread works similar to buying a long put.
Where it differs, however, is in profits. The possibility of higher profits stops with a spread.The possibility of higher profits stops with a spread, unlike that of a put.
By shorting the out-of-the-money put, you reduce the cost of the bearish position. However, you forgo the chance of making a substantial profit if the underlying asset plummets in price.
Your profits are limited, but your risk is defined.This is part of the trade off; the short put premium mitigates the cost of the strategy but also caps the profits.
A different pair of strike price choices might work, as long as the short put strike is below the long put strike. The decision you make is a matter of balancing trade offs and keeping to a realistic forecast.
When Will You Have Maximum Profits?
Maximum profit is when the price of the underlying is less than the strike price of the short put. It’s as simple as this: the stock price needs to close below the strike price of the out of the money puts on the expiration date to realize maximum profits.
Both options expire in the money. However, the put purchased with the higher strike price will have higher intrinsic value than the put you sold with the lower strike price.
Thus, your maximum profit is equal to the strike price minus the debit taken when you entered the position. Below you can see the formula for calculating maximum profit:
Your Maximum Profit = Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid – Commissions Paid.
In other words, your maximum profit is when you subtract the premium you paid with the strike prices of the short put bear put spread. Check out our trading room for real time examples of trading spreads
Here is the options chain where you’d buy your bear put spreads. Therefore, you can see what the width of the strikes are and where you’d need the stock to go in order to profit.
What Is the Maximum You Can Lose?
If the stock price goes above the in the money put option strike price at the expiration date, your maximum loss is the debit taken when entering on the trade.
Based on this, the formula for calculating maximum loss is as follows:
Your Maximum Loss = Net Premium Paid + Commissions Paid
In other words, you max loss is the premium you spent. This is the same as it would be with naked options.
However, the price of spreads are cheaper than naked options. Therefore, the loss is much less because the premium is much less.
When Do You Break Even With Bear Put Spreads?
Your breakeven point is equal to the long put strike price minus the net premium paid to enter the trade. Breakeven prices are important to know because you want to know that your trade can reach that point.
Bear Put Spread Example
Suppose ALI stock is trading at $38 in January and you have a bearish outlook. Maybe they’re poised not to meet earnings which are coming up shortly.
Based on your analysis, you decide to enter a bear put spread. You buy the FEB 40 put for $300 and sell the FEB 35 put for $100 at the same time.
The result is a net debit of $200 to enter the position. The price of ALI stock subsequently drops to $34 at expiration; which is what you want.
Both puts expire in-the-money. The FEB 40 call you bought has $600 in intrinsic value while the FEB 35 call you sold has $100 in intrinsic value.
Crunching the Numbers
When you crunch the numbers, the spread has a net value of $5 (the difference in strike price). Once you subtract the debt taken to the trade, your net profit is $300!
Not surprisingly, this is also your maximum possible profit. If the stock had rallied to $42 instead, both options expire worthless.
You lose your entire debit of $200 that you spent to enter the trade.
This is also your maximum possible loss. Which, in the grand scheme of things, isn’t much compared to that of an uncovered put.
Key Take-Away of Bear Puts
- Use a bear put spread if you’re pessimistic on a stock
- Your profits and losses are defined
- It involves simultaneously buying and selling of puts on the same underlying asset with the same expiration date but at different strike prices
- A bear put spread profits when the price of the underlying security declines
Don’t Be Afraid of Capping Profit
Bear put spreads do cap profits because of the spread strategy. That can be off putting to traders.
However, that’s normally because we’re greedy. Who doesn’t want to make thousands of dollars a trade? Is that normal though?
It can happen for sure. However, slow and steady wins the race.
Remember that one contract controls 100 shares and you can buy more than one contract. Just make sure you have the capital to do so.
Small profits add up. Safely growing your account is going to benefit you in the long run. You won’t blow up your brokerage account.
You also won’t get burnt out from taking losses. Remember, you never go broke taking your profits.
We usually expect our stocks to increase in value, not decrease. But when faced with a down market, bear put spreads can be profitable.
There will be times now or even in the future, where the stocks you want to trade just aren’t going up. And in some cases, they stay neutral.
That’s why this simple trading strategy is beneficial to have in your arsenal. It will allow you to reap benefits as your fellow traders are sitting on the sidelines, or even worse, losing money.
Let us help you get started on your options trading journey. From simple naked options to advanced strategies, we will guide you every step of the way.
If you need more help, take our options trading course.