What is Bear Put Spread Strategy?
Bear put spread is a derivatives strategy that is usually implemented when the market outlook is slightly bearish and expectations of moderate fall are there and involves buying a nearby strike put option, or an in-the-money (ITM) put option and selling a far-off strike put option or an out-of-money (OTM) put option.
Bear put spread strategy provides reasonable gains if the underlying moves as expected by the trader or investor at the inception; however, if in case the underlying moves contrary to the expectations of the trader or investor, the loss is limited to the net premium paid (difference of the premium paid on buying the nearby strike put option and premium received on selling the far-off strike put option).
Formula
Where,
- X1= Far off strike price of put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more sold
- X2= Nearby strike price of put option purchased
- ST= Closing price of underlying stock/index on expiry
- P1= Premium received on selling the far off strike put option
- P2= Premium paid on buying the nearby strike put option
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For eg:
Source: Bear Put Spread (wallstreetmojo.com)
Bear Put Spread Example
Let’s understand the concept in more detail by taking a real-life example.
Klain International has a moderately BearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more outlook on the markets in Europe and decided to enter into a bear put spread on the NIFTY INDEX to benefit from the outlook on 01.11.2019.
- The current nifty index spot level as of 01.11.2019 is 12000.
- The current price of nifty 12000PE expiring on 27.11.2019 (monthly expiry) is $140
- The current price of nifty 11800PE expiring on 27.11.2019 (monthly expiry) is $70
- The lot size is 100 units.
This is entered by:
- Buying one lot of nifty 12000PE for $140 (Total Cost= $140*100=$14000)
- Selling one lot of nifty 11800PE for $70 (Total Cost= $70*100=$7000)
- Net premium paid= $14000-$7000=$7000
Under this maximum loss to Klain International is limited to the net premium paid i.e., $7000. The maximum profit under this spread is equivalent to $13000 (100*$130). The Break-even point under the bear put spread is 11930 nifty index spot level
It reaches maximum profit when the underlying security reaches the far-off strike price put option, which in our case was 11800. And below this level, the profit will not maximize. Similarly, profit will increase between the two strike prices, i.e., 12000 and 11800, and maximum loss will be equivalent to the net premium paid.
Advantages
- It is a low-cost, limited risk options strategy that benefits when the Market outlook is moderately bearish.
- The strategy benefits even in small prices fall and doesn’t require a big fall to generate returns.
Disadvantages
- It results in a small amount of profit only as the upside is capped due to the selling of an out-of-money put option.
- It results in loss of the entire net premium if the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more starts rising.
- The spread strategy works only when the outlook is bearish.
Difference Between Bear Put Spread vs. Bear Call Spread
| Particulars | Bear Put Spread | Bear Call Spread |
|---|---|---|
| Definition | This involves buying a higher exercise price put or an In-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more (ITM) put and selling a lower exercise price put or an out-of-money (OTM) put. | Bear call spread involves selling a call with a low exercise price or an In-the-money call and buying a call with a far-off exercise price or an out-of-moneyOut-of-money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more (OTM) Call. |
| Market/Underlying Outlook | Moderately Bearish | Moderately Bearish |
| Maximum loss | The maximum loss is equal to the net premium paid. | Maximum loss is equal to the spread minus net premium credited. |
| Inflow/Outflow of Premium | It results in net premium outflow at inception. | The bear call spread results in net premium inflow at inception. |
| Suitability | Bear put spread strategy makes more sense when the market has fallen substantially, and volatility is favorable input writing, and further fall seems moderate. | The bear call spread strategy made more sense when markets increased substantially, and volatility is favorable in call writing due to huge call premium and expectation are of market consolidating or falling marginally. |
Important Points
- Both the option purchased and sold should be of the same expiry.
- Although the net premium amount paid is the maximum loss incurred in case the outlook fails; however, selling an option requires the keeping of a lot of margins, and the cost of funds of such margin needs to be accounted into while opting for such a strategy.
Conclusion
Bear put strategy is frequently used by professional traders in a moderately bearish outlook to generate moderate gains. The strategy is a low-cost, effective tool used even for hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more purposes as well. It is up to the trader/investor to determine the right strike pricesStrike PricesExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and should take into consideration the implied volatility of the underlying to make better choices.
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