What is Bear Spread?
Bear Spread is a kind of price spread where you buy either 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.
There are several ways you can trade when you feel that a stock will go down.
- Shorting a Stock
- Buying a Put
- Entering into Bear Spread
The strategies mentioned in “a” and “b” are most effective when the stock price goes down drastically. There is no protection in the above two strategies. That is, if the stock price goes up, then there will be unlimited loss in strategy “a” and limited loss in strategy “b.” They help to minimize the initial cost of Strategy “b.” It helps to reach the breakeven point faster.
Example of Bear Spread
Say the stock price in the market is 100, and the put premium at different strike prices are mentioned below:
Put @98 – Premium is 5
Put @95 – Premium is 3
- So if you would have followed strategy “b” (Buying a Put), then you would have just bought the put at strike 98. So if the stock price would have reached below 93 (98 Strike less the premium paid, this is the Breakeven point), then you would have started making a profit.
- Here you don’t think that stock price will go so low, so you are bearish, but moderately. So what will you do to minimize the premium that you need to pay for the put option? You can sell a put option below the 98 strike price. The put option that is available below the 98 strikes is 95 strike. You feel that the stock price will not go below 95. You can trade the profit potential below 95.
- So you can sell the put at the strike of 95. You will earn a premium of 3 now. Your net investment now will be 5-3=2. So you entered the strategy with an initial investment of 2. The Breakeven point changed from 93 to 96 (98-2). That is a huge improvement as you were not sure whether the stock price would reach the previous breakeven point that was 93.
So now, if the stock price stays above 100 or 98, then it will be your loss of 2. What will happen if the stock price goes below 98.
Stage 1: Stock Price above 98. You will incur a loss of 2. Because both the put options will expire. 2 was your initial investment
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Stage 2: Stock price from 98 to 96. As soon as the stock price crosses 98, the put you bought will be activated. So when the stock price reaches 96, then the gain from put will be 2. Your initial investment was -2, so you will reach Breakeven. This means there will be no profit or no loss at this stage.
Stage 3: Stock Price between 96 to 95. This is the stage where you will earn a profit. As you have already recovered the investment, so you will earn a profit of +1 here.
Stage 4: Stock Price below 95. At this stage, the put that you have sold will be activated. So you will not be able to earn any more profit from this stage. So your Net profit will remain at 1.
Types of Bear Spread Strategies
There are two types of bear spread strategies.
Bear Put Strategy has already explained above, so we will explain the Bear Call strategy here.
#1 – Bear Call Strategy
You may feel that why they have used call when the strategy is bear. So this strategy is to prove that you can use call options also when you feel that the market will go down.
The most lucrative strategy to be used in case you feel that stock price will go down is call writing, also known as Selling Call option. Call Option writing has the potential of unlimited losses if the stock price goes up instead of going down. So to safeguard from the risk of unlimited losses, investors enter into bear call strategy. They buy out of the money call at the higher strike in case the stock price rises.
#2 – Bear Put Strategy
If an investor is bearish for the market, but he is not so bearish. He thinks that the stock price will go down but will not go down drastically. He should buy a put option and minimize the cost of 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 breakeven point fast.
- It is helpful when the market is moderately bearish. So in case of extreme movements, other strategies should be used. Markets are mostly moderate in movements, so this strategy is most useful.
- 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 to protect himself from unlimited losses. In case an investor is selling a call option, then there will be unlimited potential for loss. So Bear strategy helps an investor to limit losses.
- Shorting options require huge margins, which is difficult for small investors to arrange.
- Getting the options at correct strike prices is also a big challenge as options at all possible strike prices are not available.
- 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 markets. 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 Strategy is a kind of price spread where you buy similar options like Call and Put at different strikes but the same maturities. So these strategies are designed in such a way that both profit and losses can be limited. The share market 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 give protection.
This has been a guide to what is Bear Spread. Here we discuss two types (Bear Call and Bear Put), and an example of bear spread along with advantages and disadvantages. You may also have a look at the following articles –