Put Spread Strategies: Amplifying Returns in Bearish Markets

Have you ever gotten close to finishing a puzzle, only to find there’s a piece missing? 

It’s frustrating! Think of options trading like a jigsaw puzzle, where each piece is a different trading strategy. You’ve got your foundational options strategies like put and call options, which are akin to the corner pieces that really set the scene for the puzzle. But what about the edge pieces that give it shape?

Enter the put spread strategy—a versatile and risk-controlled approach that complements your basic puts and calls. Tailored to various market outlooks, the put spread can be your missing piece that adds definition to your overall trading picture.

Just like how missing edge pieces can leave your puzzle incomplete, neglecting the use of a put spread could result in missed opportunities. In this article, we will delve deep into the two primary variations of put spread: the bull put spread for rising markets and the bear put spread for declining.

By understanding the mechanics, advantages, and pitfalls of both, you’ll be better equipped to complete your trading puzzle with precision and confidence. Ready to find that perfect fit? Let’s explore. 

Understanding the Put Spread Strategy

The put spread strategy is a fairly common strategy in options that involves the simultaneous purchase and sale of two put options. This versatile approach can be customized to fit various market outlooks, making it a go-to tool for diverse trading situations. The strategy’s flexibility largely hinges on the configuration of the put options. Let’s take a look. 

Bull Put Spread

A bull put spread is generally used when a trader has a moderately bullish outlook on the underlying asset. This strategy involves selling an in-the-money put option at a higher strike price while simultaneously buying an out-of-the-money put option at a lower strike price—both with the same expiration date. The aim? To capitalize on a slight uptick in the asset price while shielding yourself from major losses.

You can see what that looks like in this profit/ loss graph below. If the underlying price moves up slightly (move to the right on the graph), max profit, although capped, is realized. And, unlike a naked put, your loss is capped also, making it a much less risky strategy than a naked put.

This chart illustrates the break-even point in a bull put spread.

You receive a net credit with bull puts as a result of the two trades, so you may have also heard investors talk about trading put credit spreads in the context of bull put spreads. The net credit serves as your maximum profit. Meanwhile, you’ll notice in the graph that the put option you’ve purchased acts as a safety net, capping any potential losses. 

Bear Put Spread

On the other hand, if you predict a slight decline in an asset’s price, a bear put might be the move. The basic setup: buy an in-the-money put option at a higher strike price and sell an out-of-the-money put option at a lower strike price. Again, both options should have identical expiration dates. The goal here is to cash in on a downward movement in the asset’s price, all while keeping risks in check through the sold put.

Here’s what a profit/loss graph looks when it comes to trading a bear put spread:

A bear put spread is set up for a net negative (or net cost) and gains when the price of the underlying stock drops.

You’ll notice this graph is like a mirrored image of the bull put, flipped on a vertical axis. It’s the inverse of a bull put.

What makes the put spread strategy a go-to for many traders is its ability to strike a balance between potential gains and risks. By strategically choosing the strike prices and expiration dates, a trader can align the put spread with their market view, whether bullish or bearish. The simultaneous buying and selling actions in the strategy serve to offset costs and potential losses, making it a risk-controlled approach.

One key aspect that distinguishes the put spread from other strategies is its inherent flexibility. Whether you’re looking at a bull put spread for a rising market or a bear put spread for a declining one, understanding how to construct and apply these spreads allows you to navigate market swings with both confidence and precision.

How to Construct a Put Spread

Now that we have solid a foundation of put spreads, let’s put one together. Whether you’re bullish or bearish, assembling a put spread involves selecting specific key parameters tailored to your risk appetite. Let’s take a look: 

1. Identify Market View

Start by gauging your market view on the underlying asset. Your choice between a bull put spread or bear put spread will correlate to a bullish or bearish outlook, respectively.

2. Choose Strike Prices

Decide on strike prices for both the bought and sold put options. In a bull put spread, the sold put option should have a higher strike price, while the bought one should have a lower strike price. On the flip side, in a bear put spread you’ll buy a put option at a higher strike and sell one at a lower strike.

3. Determine Expiration Dates

Both put options should have the same expiration date. Use your projections on the underlying asset’s price trends to select the optimal expiration.

4. Execute the Trade

Now it’s time to execute. Simultaneously buy and sell the two puts, sticking to the strike prices and expiration dates selected.

Risk Analysis of Put Spreads

It’s crucial to keep your risk exposure in check, so let’s look at some of the nuances associated with put spreads. Both bull and bear put spreads come with their own risk characteristics: 

Understanding the Risks of a Bull Put Spread

In this setup, the risk you take on (max loss) is limited to the difference between the strike prices minus the net premium received. This worst-case scenario will happen if the underlying asset’s price falls below the lower strike price. The best case scenario, or max profit is the underlying price moves up slightly and you keep the credit you initially received.

The Risk of a Bear Put Spread

Here, risk, or max loss, is equal to the difference between the strike prices minus the net premium paid. This is the most you can lose if the underlying asset’s price rises above the lower strike price. Best case scenario here (max profit) is to capture the difference between the strike prices minus the net cost of the spread.

Risk Management Measures

You can set up some safeguards that help prevent the worst-case scenario from happening. For bull put spreads, consider employing rolling strategies. If the underlying asset starts to decline, you might “roll down” your spread to lower strike prices, reducing potential losses while remaining in the trade.

In contrast, with bear put spreads, closely monitoring the delta, one of the ‘Greeks’ in options, can be a useful measure. A higher delta indicates a greater sensitivity to price movements, so adjusting your bear put spread to a lower delta can minimize risk in a rising market.

Additionally, for both types of spreads, setting aside capital to adjust the spread or close it out entirely in case of adverse market movements can provide an added layer of risk mitigation.

Lastly, if you are like many of us and have other responsibilities that’d pull your attention from trading, you can always use stop-loss orders, and or set yourself up with options signals from veteran traders, that way you have an extra set of eyes if you’re busy with other things.

Put Spread vs. Call Spread

Put spreads and call spreads are both key tools in an options trader’s toolkit. They’re similar because they both use two option contracts, but they’re used in different situations depending on what you expect the market to do.

With a put spread, you’ve got options. You can go for a bull put spread if you think the asset’s price is going to stay the same or go up. If you expect the price to drop, then a bear put spread is your move.

Call spreads are a bit different. A bull call spread is what you’d use if you’re expecting a price increase. A bear call spread is better if you think the price will stay the same or go down.

So what’s the key difference? It’s mostly about flexibility. Put spreads can work in a lot of different market conditions. Call spreads are often better when you have a strong opinion about where the market is headed. Simply put, if you’re not sure or expect stability, consider a put spread. If you’re feeling strongly bullish or bearish, maybe a call spread is more your speed. 

Practical Example of Put Spread

Let’s take Amazon (AMZN) and say it’s currently trading at $135. You’re predicting a moderate price increase because you saw Shopify partnered with them, but you don’t think it’ll be that big of a deal.

To make some money off this, you decide to set up a bull put spread. You sell a put option with a $125 strike price and get a $8 premium for it. At the same time, you buy a $115 put option for a $4 premium. Both options have the same expiration date.

By selling the $125 put, you’re making money right off the bat. Buying the $115 put is like your safety net, limiting how much you could lose. Overall, you’ve made a net $4. If the stock stays above $125 until the options expire, you get to keep the whole premium. If the stock price falls between $125 and $115, you’ll make less but still come out ahead. And if the price drops below $115, your losses are capped thanks to the $115 put you bought. 

Pros and Cons of Put Spread

Put spreads are pretty handy if you’re looking to limit how much you could lose in a trade. They’re a more cautious way to get into the market, especially since they often cost less upfront than buying just one put option. 

Pros

• Limited Risk
• Potential for Moderate Profit
• Flexibility

Cons

• Capped Profit
• Complexity for Beginners
• Requires Accurate Market Prediction

But here’s the catch: The very thing that limits your risk also caps how much you can make. So, you’re trading the chance for big gains for a bit more peace of mind. Put spreads are also not the simplest strategy around; you’ve got to know the basics of trading options. This can make them a bit tricky for newbies. 

Conclusion

Wrapping things up, put spreads may be a missing edge piece to your trading puzzle. This is a foundational strategy in trading. It’s a nuanced approach, allowing you to tailor your market moves according to specific bullish, bearish, or neutral outlooks. By mastering both bull and bear put spreads, you’re effectively fitting key puzzle pieces into your broader trading strategy. 

But to really integrate this strategy, you’ll need to embrace more than just the basics. Mastery comes with an understanding of finer techniques like placing advanced order types such as stop-loss orders, rolling options, and monitoring delta. In essence, the put spread isn’t a standalone element but part of a comprehensive risk management system, offering a balanced approach that tempers risks while still leaving room for moderate gains. 

So as you navigate the intricacies of options trading, consider the put spread as more than just another tool—it can be a vital piece in completing your puzzle. Keep practicing and refining your understanding, and you’ll find that this versatile strategy can indeed help you assemble a clearer, more complete market picture. 

Put Spreads 101: FAQs

What Sets a Put Spread Apart From Other Hedging Strategies?

A put spread is distinctive because it allows traders to limit risk and potential loss while preserving the opportunity for profit. By simultaneously buying and selling put options at different strike prices, traders can tailor the strategy to align with their market outlook, effectively hedging against adverse price movements.

Under What Market Conditions Might a Bear Put Spread be Preferable?

A bear put spread is often preferable in a bearish or declining market. This strategy allows traders to profit from a decrease in the underlying asset’s price, making it an attractive option when anticipating downward price movement.

How Can One Tailor a Put Spread to Align with Individual Risk Tolerance?

Tailoring a put spread involves selecting appropriate strike prices and expiration dates that align with the trader’s risk tolerance and market view. By adjusting these parameters, the trader can create a Put Spread that fits their comfort level with risk and their expectations for market movement.

How Does a Put Spread Differ From a Call Spread, and When Might One be Chosen Over the Other?

A put spread focuses on profiting from or hedging against a decline in the underlying asset’s price, while a call spread targets gains from an increase. Choosing between these strategies depends on the trader’s market outlook; a put spread is typically chosen in a bearish scenario, while a call spread is preferred in a bullish one.

What are the Common Mistakes Traders Make When Setting up a Put Spread?

Common mistakes include choosing inappropriate strike prices, not considering the impact of transaction costs, misunderstanding the risk profile, or failing to manage the trade properly once it’s in place. These errors can significantly impact the effectiveness of the strategy.

Can a Put Spread be Adjusted Mid-Trade, and if so, What are the Considerations?

Yes, a put spread can be adjusted mid-trade by closing or rolling the positions to different strike prices or expiration dates.