A ‘Bear Put Spread’ is a kind of options strategy used by an option trader, when they expect the price of the underlying asset to decline moderately, in the near future. The bear put strategy is achieved by purchasing an in-the-money put option at a higher strike price than the market price of the underlying asset. An out-of-the-money (OTM) put option with the same expiry date is sold at a strike price lower than the market price of the underlying asset to complete the procedure.
The maximum profit to be gained by employing this kind of strategy is equal to the difference between the two strike prices, minus the net cost of the options. The options trader in anticipation of a plunge in the price of the underlying asset shorts the OTM put option. This reduces the cost of establishing the bearish position, but at the price of losing the chance to have made a large profit. Upon entering the trade a debit is taken which gives the bear put spread options strategy another name: bear put debit spread. The net debit is the difference between the sale and purchase of the two options. If one expects the market to fall they can also enter a credit spread, and this is known as a bear call spread.
To extract maximum profit from this strategy, the OTM puts will need to have their stock price close below the strike price on the expiration date. Both the calls and put options expire in the money, however, there will be higher intrinsic value in those puts purchased at a higher strike, than the lower strike put that was sold. In this way, we come to the crux of the bear put strategy and produce the maximum profit equal to the difference between the two strike prices, minus the net debit taken when the position was entered.
To calculate the maximum profit, we can use the following formula:
Maximum Profit= Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid - Commissions Paid
This is only achieved when,
Price of underlying ≤Strike price of short put
Conversely, the bear put strategy can also suffer from loss. Its maximum loss is realized when the stock price rises above the strike price of the in-the-money put option at the expiry date. The maximum loss is equal to the debit incurred when putting on the trade.
To calculate the maximum loss, we can use the following formula:
Maximum Loss=Net Premium Paid+Commissions Paid
This is only achieved when,
Price of underlying ≥Strike price of long put
To calculate the underlier price at the breakeven point for the bear put spread, we can use the following formula:
Breakeven Point=Strike Price of Long Put-Net Premium Paid
To better illustrate the concept of the bear put spread, let’s take an example in which we suppose a certain XYZ stock is trading at $38 in June. An options trader decides to proceed into a bear put spread as he is bearish about XYZ. To enter the position he will, at the same time, buy a JUL 40 put for $300 and sell a JUL 35 put for $100. This results in a net debit of $200.
On expiration, the price of the XYZ stock plummets to $35. Both puts expire in-the-money with the bought JUL 40 put having $500 in intrinsic value and the JUL 35 put sold having $0 in intrinsic value. The difference in the strike prices gives us the net value of the spread, which is $5 here. To calculate the net profit, we deduct the debit taken when the trader placed the trade and get $300 in net profit (which is also the maximum possible profit).
If instead, the stock had recuperated to $42 at expiration, then both the options would have expired without any value and the trader loses the entire debit of $200 (which amounts to the maximum loss), when he entered the trade.
We did not factor in the account commission charges in the above calculations to make the concept easier to understand and also because they are negligibly small, usually at about $10 to $20 and vary across options brokerages. But in the long run, commission charges can eat up a noticeable amount of profits for active traders, which is why it would be wise to seek a low commission broker if you are an active options trader. After doing some good research, one can find brokers which charge as low as $0.15 per contract (+$8.95 per trade).