Lesson Objective: Understanding Bear Put (Debit) Spreads
| Category | Description | Example |
| Key Components | a) Long put
b) Short put with a lower strike |
1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2 |
| Why Use Bear Put Spreads? | The bear put debit spread gives the buyer of the spread the opportunity of being exposed to an underlying in a similar fashion to buying an outright put but at a cheaper cost since the buyer also receives a credit for selling another put at a lower strike. The catch being that the exposure to the underlying’s potential downside is limited to the strike of the short put.
It is called a debit spread because it is entered for a net debit. |
1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2 Instead of holding an XYZ Jun 20xx $100 Put for a $5 cost, the buyer holds the put for a (net) debit of $3. However, the buyer will only benefit from a decrease of the underlying up to $95. Beyond, s/he will not participate in any downside because of the put that has been sold. |
| When to Use Bear Put Spreads (outlook)? | When you are moderately bearish on the underlying, hence the term “bear” put spread. If you were really bearish you would buy an outright put instead. | |
| Main Risks or Drawbacks of Using Bear Put Spreads | You could lose most or all of your investment (net debit paid) if the underlying has moved sideways or risen at expiration. In fact, for you to make any profit, the underlying must have declined at least by the amount of net premium paid at expiration. | |
| The Set Up | A bear put debit spread is a type of vertical spread. A vertical spread involves the purchase and the sale of puts (or calls) on the same underlying, with the same expiration but with different strikes. The term “vertical” comes from the position of the strike prices (typically one on top of the other) as can be seen on the screen of a broker’s platform.
In the present case, you will have to decide what strikes to select for each put, which warrants a trade-off between different parameters: (1) the maximum risk you are willing to take (i.e., how much premium you will pay upfront), (2) the risk/reward you will accept (see P&L Chart section below), and (3) the probability of success (i.e., probability of making any profit), which is usually provided by your broker’s platform. |
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| Net Debit or Net Debit? | As a net buyer of options, this strategy is established for a net debit. | |
| Maximum Profit | Profit is limited to the distance between the strike of the long put less the strike of the short put minus the net premium paid. It is reached when the underlying moves to or below the strike of the short put. | 1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2 Maximum profit of $2 [($100 – $95) – $3] per share. |
| Breakeven Price | Strike of the long put minus net premium paid | 1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2 Breakeven at $97 ($100 – $3). |
| Maximum Loss | The maximum loss equals the net premium paid and is reached when the underlying moves to the strike of the long put and above. | 1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2 Maximum loss of $3 ($5 – $2) per share. |
| Profit and Loss (P&L) Chart at Expiration | The P&L chart graphically represents the risk profile of a strategy.
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1) Buy XYZ Jun 20xx $100 Put for $5
2) Sell XYZ Jun 20xx $95 Put for $2
Note: · The maximum profit of $2 [($100 – $95) – $3] if the price of XYZ is at or below $95 at expiration · The breakeven point at $97 · The maximum loss of $3 if the price of XYZ is at or above $100 at expiration · The risk/reward ratio: 1.5 or 3-to-2 ($3 max loss / $2 max profit) |
| Effect of Price Movements | The overall position will benefit if the underlying is declining so, it has a net negative Delta. However, to be profitable the underlying will need to decrease to (or below) the breakeven price at expiration.
On the other hand, if the underlying rises, moves sideways, or even slightly down but not below the breakeven point then the overall position will lose value at expiration. |
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| Effect of Time | The significance of time decay will depend upon the distance of the underlying from the strikes of the bear put spread.
Recall that long calls and long puts almost always carry negative Theta (because time only moves in one direction and the option holder has less and less time to be “right”) while short calls and short puts almost always carry positive Theta. If the underlying is above or near the strike of the long put, then the value of the spread depreciates (you lose money) with the passing of time because you hold a net long position and the (near-the-money) long put is eroded by the passing of time at a faster rate than the OTM short put (all else being equal) so, you would carry a net negative Theta. Conversely, if the underlying is below or near the strike of the short put, then the value of the spread appreciates (you make money) with the passing of time because the (near-the-money) short put is eroded by the passing of time at a faster rate than the ITM long put (all else being equal) so, you would carry a net positive Theta. If the underlying is somewhat equidistant to the strikes, then time decay has little effect on the overall value of the spread as the respective impact on the puts will offset each other. |
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| Effect of Volatility | Here again, the effect of implied volatility depends on where the underlying stands relative to the strikes of the spread.
Recall that long options have positive Vega while short options have negative Vega, and Vega is usually at its highest for ATM options because these options are more sensitive to changes in the volatility of the underlying. If the underlying is above or near the strike of the long put, then the spread will gain in value (you make money) if implied volatility increases because this will increase the value of the (near-the-money) long put faster than it will decrease the value of the OTM short put. Conversely, if the underlying is below or near the strike of the short put, then the spread will gain in value (you make money) if implied volatility decreases because this will increase the value of the (near-the-money) short put faster than it will decrease the value of the ITM long put. If the underlying is somewhat equidistant to the strikes, then volatility has little effect on the overall value of the spread as the respective impact on the puts will offset each other. |
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| Assignment Risk | While the long put has no risk of early assignment, the short put does have such risk. | |
| Approval Level Required by Brokers | Usually, the trading of bear put spreads is authorized by brokers for most traders/investors since you have limited risk. However, this is a fairly complex strategy that require some proper risk management after the initial setup. | |
