When you go into an ice cream store, would you rather have a choice between three flavors or 30 flavors?
I’d imagine most would say 30 flavors. But at least with three, you might have a less difficult time deciding.
There are many flavors, or strategies, used in the stock market by investors hoping to capture profit. And with options, you discover that there are dozens more flavors on top of that!
The trouble is, which one do you choose? And why?
In this article we’re going to discuss in detail one specific flavor of options, the bear put spread. We want you to understand the strategy well enough so that you’ll know when it’s the right time to choose it over other ‘flavors’.
Bear puts are a fairly simple strategy that can be utilized when you are feeling moderately bearish. The play separates itself from an even more simple play, a long put, by essentially providing you a discount for a long put. The key is knowing how to set it up, and when to execute the strategy.
Let’s get into it.
What is a Bear Put Spread, Exactly?
Bear put spreads fall under the category of vertical spreads. The play involves two puts that have the same expiration date but different strike prices. To set up the play, an investor would long, or purchase the put with the higher strike price – and short/ write, or sell, the put with the lower strike price.
The max profit a bear spread can earn is equal to the difference of the strike prices (times 100 shares), less the total cost paid for the puts. We’ll get into a more specific example later, but that’s a quick snapshot.
If you need a quick refresher, or have never heard of puts: Puts are one of two types of options and give you the right, but not the obligation, to sell stock (100 shares) at a set price, over a set period of time. Another popular put option strategy is the covered put – but it requires a slightly higher risk tolerance than the bear put spread, so they will be covered in separate guides.
Understand How Bear Put Spread Works
Alright, let’s dive a little deeper into understanding this strategy.
One thing to note with bear put spreads is that the trades will result in a net debit. Accounting 101: debit means money going out, credit means money coming in. So with a bear put you will end up spending money, as opposed to receiving money in the form of a premium.
This is because with puts, it is always advantageous to have a put with a higher strike price, because you have the right to sell at a higher price. This means the put with the higher strike price has more value and therefore has a higher premium, or price.
So one way to think about this strategy is that you are essentially entering into a discounted long put position. Normally you could just long a put, but in the case of this strategy, you long a put and then receive a premium for the put you shorted.
Discussing the Strategy
So when should an investor use this strategy? While this play doesn’t constitute a simple options trading strategy, implementing it is pretty straightforward. The easiest way to think about it is, that a long put is a purely bearish strategy, whereas a bear put spread is a moderately bearish strategy. So use the play when you think there will be a slight price decline.
But why are bear put spreads not ‘purely’ bearish? This is because the more the price of the underlying falls, the more likely it is for an investor to exercise the short option, which would force you to provide the 100 shares to the investor you sold the put to.
So the key here is just to watch the underlying price closely, which is a nice lead-up to the next section, changes in the underlying price.
Stock Price Change
Changes in underlying prices heavily, and directly influence options premium. The movement of the underlying price can help investors’ when to hold, sell, or exercise their option(s). And with this strategy, in particular, you want to monitor the underlying price closely by using a portfolio tracker or app, making sure it’s not falling too much, creating a potential opportunity for the investor to exercise.
A common trading tip to stay organized in this regard is to keep a trade journal. Recording your moves – either in a physical notebook or through a spreadsheet on your computer – has many benefits. It can help you observe previous moves and identifies tendencies, which you can eventually overcome to bring your trading to the next level.
In the end, if you’re concerned about assignment, just remember, that you can always close one or more of your positions. So you can take a deep breath. You aren’t locked into anything. You can buy it back and close it.
Analyzing Changes in Underlying Price
But how much does the underlying price actually affect the premium? One way investors can analyze this is to use something called “delta”. Delta is one of the four main “Greeks” used to measure how outside factors affect options.
Delta is the predicted, or theoretical measure of how much the premium of an option will change based on a $1 movement in the underlying stock. You cannot have a delta higher than 1 or lower than (-1). Deltas are typically higher when a contract is out-of-the-money, closer to 1, -1; and lower when they are closer at-the-money, closer to 0.5, -0.5.
So how would you use delta? Delta works in a similar way to a stock’s beta, if you’re familiar with that metric. For example, if an option has a delta of 0.7, and the underlying stock moves $1, the premium of the option changes by $0.7, in theory.
Time decay might be enemy number one for options traders.
Think of an option contract you long as an ice cream cone you’re holding on the beach during the summer. The value of the option is the ice cream, and for every minute that passes, the ice cream melts, just like the premium.
The further out an expiration date is, the less of an effect time decay has on an option’s premium because there is more time for the option to move in a favorable direction for the trader. This is measured through one of the Options Greeks called Theta. That means the further into the future an expiration date is, the more valuable the contract will be.
Moreover, the rate at which the premium falls due to time decay is not constant but exponentially increases as the option gets closer to its expiration date (see the image below). This will play a role in an investor’s decision on when to close the position.
The Risks of Early Assignment
With options that you long, assignment is never a risk. But if you short (aka sell, or write) an option, you always risk assignment. Assignment happens when the investor on the other side of the contract, the person you ‘sold’ the option to, exercises their rights of the contract, so you are left having to provide the 100 shares.
We’ve talked about exercising/ assignment a few times now, if that worries you, know that less than 10% of all option contracts are actually exercised. Still, you should always make sure that when you short an option make sure you have enough capital to comfortably spend on 100 shares of the underlying stock to protect yourself.
This context is a good time to point out a very important lesson: risk management is a key component of any sustainable options trading strategy. Using calculated stop losses, trading without any emotion whatsoever, clearly defining sell targets from the start, and following alerts for trading stocks and options are key ways in which traders can minimize risk and further increase their chances of success.
Earnings and Losses with Bear Put Spread
Your maximum profit/ gain with a bear put spread is equal to the difference of the strike prices (times 100 shares), less the total cost paid for the puts.
Strike Price 1: S1
Strike Price 2: S2
Long Put premium: LP
Short Put premium: SP
Max Profit: MP
MP = (S1 – S2) – (LP + SP)
Your max risk with this play is similar to a long put. Namely, your max loss (generally) is the total cost of the play which includes commissions if you paid any.
Long Put Premium: LP
Short Put Premium: SP
Commissions Paid: CP
Max Loss: ML
ML = LP – SP – CP
Note: The only time where this would not be your max loss is if the put was assigned.
The break-even point of a bear put spread is equal to the higher strike price, and, less the net debit paid.
Net Debit: ND = Premium of the put with the higher strike – premium of the put with the lower strike
Higher strike price: HSP
Let’s say this higher strike price is $100, and your net debit is $1.00. In this case, the investor would break even.
HSP = $100
ND = $3.00 – $2.00 = $1.00
$100 – ($1.00 * 100) = $0 = BE
Example of Bear Put Spread
We’ll use Microsoft (MSFT) in this example.
Say that an investor thinks its price is going to go down slightly at some point in the future, so they decide to set up a bear put spread to capture some profit on the way down.
For simplicity’s sake, say MSFT is trading at $300.
To set up the play, first (although it doesn’t matter the order) the investor longs one MSFT put with a $285 strike price, and shorts one MSFT put with a lower strike price, $275.
The premium of the long put is $5.15 and the premium of the short put is $2.94, leaving them with a $2.21 net debit.
Both puts need to have the same expiration date, and the investor decides to set it to a month out so there is enough time for the price to fall so they can collect profit, but not too far out so the price doesn’t have time to rebound, putting the play squarely into the territory of swing trading.
The break-even point is equal to the higher strike price, minus the net debit. In this case, the break-even point would be $279.85. So if MSFT closes above $279.85 on the expiration date, the max loss would be their net debit ($2.21), less any commissions paid.
The max gain is the difference in strike prices, less the net debit of the trades, less any commissions paid. In this case that would be $7.79 [($285 – $275) – $2.21]. However, to close the position the investor needs to buy back the put he sold. So the ‘real’ max profit would be $4.85 ($7.79 – $2.94).
Pros and Cons
There is a lot of polarity interplay with the advantages and disadvantages of bear puts spreads – its strengths and weaknesses work paradoxically, as they sort of cancel each other out.
Here are some examples:
- Pro: You end up paying less for the overall investment because you entered into a short position.
– But, you run the risk of being assigned that short position.
- Con: You restrict your max profit to only the difference in strike prices (less the total paid)
– But, you reduce the risk you pay overall by selling a put.
- Pro/ Con: you lose money as the underlying price rises, but you earn money as the underlying price falls.
You can see from these examples that this is a pretty balanced play, so much of your success with the play all comes down to how it is executed. Keep in mind that, just like with all other options trading strategies, only time will tell whether or not it is working – sticking with a strategy for at least 3 months is a good benchmark to determine if the approach works.
Bear put spreads are an intermediate (in terms of difficulty to understand), moderately bearish options strategy. One way investors think of this play is to enter a discounted put position.
There is not very much risk outside of early assignment, and you can always protect yourself against this by simply watching the underlying price and closing your position if you fear that you’ll be assigned the contract.
Understanding the Bear Put Spread: FAQs
Which is Better: Bear Call Spread or Bear Put Spread?
Both bear put spreads and bear call spreads can be effective strategies, but whichever one is the best for you is entirely circumstantial. Both are bearish strategies, but they profit very differently. Where a bear put receives a net debit, a bear call receives a net credit.
When Should I Leave a Bear Put Spread?
If the underlying price starts to fall too much, you should leave a bear put spread. The “too much” factor would be when it would become profitable for the investor you sold a put to, to exercise the position.
You should also think about leaving a bear put spread as it gets closer to expiration. As we touched on earlier, options premiums melt away due to time decay, especially as it gets closer to expiration.
How Do You Manage a Bear Put Spread?
The best way to manage a bear put spread is to closely monitor the underlying price, this will distract the decision you make in your management of the spread. Set a price you are comfortable with, and close the position if the underlying price falls beneath that.
Now, if the underlying price begins to rise, it’s completely up to you how long you want to hold on to it. It also depends on how close the expiration date is. If the underlying price for some reason skyrockets, and it’s very close to expiration, it may be best, unfortunately, to let the position expire worthless or just close it.
Lastly, if the price is falling just slightly, and you start to see your positions profiting, close it and take the profits at a price you’re comfortable with. It’s easy to get greedy and want to hold on to the position after it begins to profit, but be disciplined and try to not let your emotions influence how you manage the spread.
Is a Put Spread Bullish or Bearish?
A bear put spread is a moderately bearish options strategy.
How Do You Make Money on a Put Spread?
With a bear put spread, you capture profit as the underlying price falls. You earn money on a bear put spread if the difference in the strike prices of the options is more than what you paid to set up the position.
Can You Make Money Trading Options in a Bear Market?
Yes, you can absolutely make money trading options in a bear market. The simplest strategy in options that can capture profit in a bear market is purchasing a put option. You can also set up a bear put spread if you want the position to be discounted. These are just two of many different ways you can trade options to make money in a bear market.
What is Max Profit on a Put?
The max profit on a put is always equal to the strike price of the put less the price paid for the put, minus commission fees.