What Is Bear Spread?
Bear Spread is a kind of price spread where you buy, call or put options at different strike prices having the same expiration and is used when an investor thinks that a stock price will go down, but it will not go down drastically.
A bear spread helps gain profits while minimizing risks when the prices of stocks start declining. Investors can book a deal as soon as they find the market turning bearish. Like shorting a stock and buying a put, entering a bear spread is yet another way of trading stocks when the prices go down.
Table of contents
- A bear spread involves purchasing put, call, or buy options at varying Strike Prices with the same expiration date. This strategy is utilized when an investor believes a stock’s price will remain unchanged but not significantly.
- The bear spread strategies are the bear call and bear put strategies.
- It uses call and put options with different strikes but the same maturities to limit potential profits and losses. This approach protects the unpredictable stock market and can be helpful in uncertain times.
Bear Spread Explained
The bear spread strategy entails a price spread where one buys similar options like call and put at different strikes but with the same maturities. These strategies are designed to limit both profits and losses. The share marketShare MarketThe share market is a public exchange where one can buy and sell company shares based on the demand and supply of shares. has become extremely unpredictable. The market mostly runs on sentiments now. So, one must protect himself in case he is taking any position. Bear spread strategies, in short, offer protection to traders.
Though shorting a stock or buying a put could be an effective measure so far as reaping profits while the stock prices decline, these are most effective when the stock price decreases drastically. They offer no protection to traders/investors. If the stock price goes up, there will be unlimited loss while shorting stocks, while limited loss while buying a put. However, when the bear spread formula is applied, it helps to minimize the initial cost of buying a put, thereby helping it to reach the breakeven point faster.
Let us consider the following example to understand how it works. Strategy “a” in the example refers to the option of shorting a stock.
Say the stock price in the market is 100, and the put premium at different 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. are mentioned below:
Put @98 – Premium is 5
Put @95 – Premium is 3
- So, if traders follow strategy “b” (Buying a Put), they would have just bought the put at strike 98. If the stock price had reached below 93 (98 Strike less the premium paid, this is the Breakeven point), they would have started making a profit.
- Here, they don’t think that stock price will go so low, so they are bearish, but moderate. So, what will they do to minimize the premium to be paid for the 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.. They can sell a put option below the 98 strike price. The put option that is available below the 98 strikes is 95 strikes. Now they might feel that the stock price will not go below 95 and hence, trade the profit potential below 95.
- So, they can sell the put at the strike of 95, earning a premium of 3 now. The net investmentNet InvestmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth. now will be 5-3=2. So, they enter the strategy with an initial investment of 2. The break-even point changed from 93 to 96 (98-2). That is a huge improvement as they were unsure whether the stock price would even reach the previous breakeven point, 93.
So now, if the stock price stays above 100 or 98, it will be the second loss of 2. Now, what if the stock price goes below 98? The following scenarios may occur:
Stage 1: If the stock price is above 98, investors will incur a loss of 2 as both the put options will expire and 2 was the initial investment.
Stage 2: If the stock price remains from 98 to 96. When the stock price crosses 98, the put bought will be activated. So when the stock price reaches 96, the gain from put will be 2. Hence, the initial investment recorded is -2, which makes investors reach break-even. This means there will be no profit or no loss at this stage.
Stage 3: If the stock price is between 96 to 95. This is the stage where one earns a profit. As investors have recovered the investment, they will earn a profit of +1 here.
Stage 4: If the stock price falls below 95. At this stage, the put that sold will be activated. So, one is unable to earn any more profit from this stage. Hence, the net profit will remain at 1.
Types of Strategies
There are two types of bear spread strategies.
#1 – Bear Call Strategy
One may wonder why they have used calls when the strategy is bearish. So, this strategy is to prove that one can also use call options when they feel the market will go down.
The most lucrative strategy to be used in case the investors feel that stock price will go down is call writing, also known as the Selling Call option. Call Option writingCall Option WritingIn writing a call option, a person sells the call option to the holder (buyer) and is obliged to sell the shares at the strike price if the holder exercises it. In exchange, the seller receives a premium from the buyer. has the potential unlimited losses if the stock price goes up instead of going down. So to safeguard from the risk of unlimited losses, investors enter into a bear call strategy. They buy out of the moneyOut Of The 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. call at the higher strike in case of the stock price rises.
#2 – Bear Put Strategy
If an investor is bearish about the market, they are not so bearish. They may think the stock price will go down but will not decrease drastically and hence they decide to buy a put option and minimize the cost of the premium paid. He should sell another out-of-the-money put option. The premium earned from the out-of-the-money will help to lower the initial cost and help to reach the breakeven point fast.
The bear spread comes with a lot of benefits for the investors/traders who use it. Let us check out some of them:
- Markets are mostly moderate in movements, so this strategy is most useful. It is helpful when the market is 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.. So in case of extreme movements, other strategies should be used.
- The bear strategy helps to reduce the cost of buying a put when a person is moderately bearish. The lower cost will help him to reach the breakeven point fast.
- Bear Strategy also helps an investor protect himself from unlimited losses. If an investor is selling a call option, there will be unlimited potential for loss. So Bear’s strategy helps an investor to limit losses.
Bear spread also comes with flaws. Let us have a look at a few of them:
- Shorting options requires huge margins, which is difficult for small investors to arrange.
- Getting the options at the correct strike prices is also a big challenge as options at all possible strike prices are unavailable.
- There are transaction charges, brokerage charges, and several other charges which may prevent an investor from earning the optimum profit.
- Not all stocks are present in derivative marketsDerivative MarketsThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.. So if the stock doesn’t have options running in the derivative market, then it will not be possible to make these strategies.
Bear Spread Vs Bull Spread
Bear spread and bull spread are two terms in the stock market. Though both the terms help one to make a profit even in a riskier situation, they mean different things for different traders and investors. Each of these spreads offers two options – a call option (option to buy) and a put option (option to sell). Besides this, they differ in multiple aspects, a few of which have been listed below:
- While bear spread occurs when a trader sells a call option at a strike price, and then buys it at a higher strike price later, bull spread occurs when traders use strike prices between the high and low prices at which traders want to trade a security.
- The bear spread is used to reduce the chances of loss and maximize the chances of profits. On the contrary, the bull spread helps mitigate the risk potential of a deal expected to reap profits.
Frequently Asked Questions (FAQs)
When one is somewhat bearish and wants to maximize profit while minimizing losses, they adopt the options technique known as a bear spread. When the underlying security price decreases, the objective is to make money for the investor.
A bull call spread approach work when you are positive on the market but anticipate that the underlying will only increase slightly in the near term. When you have a pessimistic outlook on the market, you should employ the bear call spread options strategy. If prime movement goes against your expectations, the method reduces your risk.
If the stock price has risen, an iron condor can be formed by opening an opposite bull put credit spread underneath the call spread. If the spread width and quantity of contracts stay the same, tremendous credit will be received while no new risk is introduced to the position.
This has been a guide to what is Bear Spread. We explain it along with examples, vs bull spread, and types of strategies, advantages & disadvantages. You may also have a look at the following articles –