What is a bear put spread?

A bear put spread, also known as a bear put debit spread, is a type of options strategy used
when an options trader expects a decline in the price of the underlying asset. A bear put
spread is achieved by purchasing put options at a specific strike price while also selling the
same number of puts with the same expiration date at a lower strike price. The maximum
profit using this strategy is equal to the difference between the two strike prices, minus the
net cost of the options.

EXAMPLE

 Long 1 XYZ 60 put

 Short 1 XYZ 55 put

MAXIMUM GAIN

 High strike - low strike - net premium paid

MAXIMUM LOSS

 Net premium paid

The lower the short put strike, the higher the potential maximum profit; but that benefit has to
be weighed against the disadvantage: a smaller amount of premium received.

It is interesting to compare this strategy to the bear call spread. The profit/loss payoff profiles
are exactly the same, once adjusted for the net cost to carry. The chief difference is the timing
of the cash flows. The bear put spread requires a known initial outlay for an unknown
eventual return; the bear call spread produces a known initial cash inflow in exchange for a
possible outlay later on.
Limited Downside Profit

To reach maximum profit, the stock price need to close below the strike price of the out-of-
the-money puts on the expiration date. Both options expire in the money but the higher strike
put that was purchased will have higher intrinsic value than the lower strike put that was sold.
Thus, maximum profit for the bear put spread option strategy is equal to the difference in
strike price minus the debit taken when the position was entered.

The formula for calculating maximum profit is given below:

 Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid -
Commissions Paid

 Max Profit Achieved When Price of Underlying <= Strike Price of Short Put
Limited Upside Risk

If the stock price rise above the in-the-money put option strike price at the expiration date,
then the bear put spread strategy suffers a maximum loss equal to the debit taken when
putting on the trade.

The formula for calculating maximum loss is given below:

 Max Loss = Net Premium Paid + Commissions Paid

 Max Loss Occurs When Price of Underlying >= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the bear put spread position can be
calculated using the following formula.

 Breakeven Point = Strike Price of Long Put - Net Premium Paid

Summary

A bear put spread consists of buying one put and selling another put, at a lower strike, to
offset part of the upfront cost. The spread generally profits if the stock price moves lower.
The potential profit is limited, but so is the risk should the stock unexpectedly rally.

Motivation
Profit from a near-term decline in the underlying stock.

Variations

A vertical put spread can be a bullish or bearish strategy, depending on how the strike prices
are selected for the long and short positions. See bull put spread for the bullish counterpart.

Max Loss

The maximum loss is limited. The worst that can happen at expiration is for the stock to be
above the higher (long put) strike price. In that case, both put options expire worthless, and
the loss incurred is simply the initial outlay for the position (the debit).

Max Gain

The maximum gain is limited. The best that can happen is for the stock price to be below the
lower strike at expiration. The upper limit of profitability is reached at that point, even if the
stock were to decline further. Assuming the stock price is below both strike prices at
expiration, the investor would exercise the long put component and presumably be assigned
on the short put. So, the stock is sold at the higher (long put strike) price and simultaneously
bought at the lower (short put strike) price. The maximum profit then is the difference
between the two strikes prices, less the initial outlay (the debit) paid to establish the spread.

Profit/Loss

Both the potential profit and loss for this strategy are very limited and very well defined. The
net premium paid at the outset establishes the maximum risk, and the short put strike price
sets the upper boundary, beyond which further stock price erosion won't improve the
profitability. The maximum profit is limited to the difference between the strike prices, less
the debit paid to put on the position.

The investor can alter the profit/loss boundaries by selecting different strike prices. However,
each choice represents the classic risk/reward tradeoff: greater opportunities and risk, versus
more limited opportunities and risk.

Breakeven
This strategy breaks even if, at expiration, the stock price is below the upper strike by the
amount of the initial outlay (the debit). In that case, the short put would expire worthless, and
the long put's intrinsic value would equal the debit.

Breakeven = long put strike - net debit paid

Volatility

Slight, all other things being equal. Since the strategy involves being short one put and long
another with the same expiration, the effects of volatility shifts on the two contracts may
offset each other to a large degree.

Note, however, that the stock price can move in such a way that a volatility change would
affect one price more than the other.

Time Decay

The passage of time hurts the position, though not quite as much as it does an plain long put
position. Since the strategy involves being long one put and short another with the same
expiration, the effects of time decay on the two contracts may offset each other to a large
degree.

Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to
think the passage of time would be somewhat of a negative. This strategy requires a non-
refundable initial investment. If there are to be any returns on the investment, they must be
realized by expiration. As expiration nears, so does the deadline for achieving any profits.

Assignment Risk

Yes. Early assignment, while possible at any time, generally occurs only when a put option
goes deep into-the-money. Be warned, however, that using the long put to cover the short put
assignment will require financing a long stock position for one business day.

And be aware, any situation where a stock is involved in a restructuring or capitalization

event, such as for example a merger, takeover, spin-off or special dividend, could completely
upset typical expectations regarding early exercise of options on the stock.

Expiration Risk
Yes. If held into expiration, this strategy entails added risk. The investor cannot know for sure
until the following Monday whether or not the short put was assigned. The problem is most
acute if the stock is trading just below, at or just above the short put strike. Guessing wrong
either way could be costly.

Assume that on Friday afternoon the long put is deep-in-the-money, and that the short put is
roughly at-the-money. Exercise (stock sale) is certain, but assignment (stock purchase) isn't.
If the investor guesses wrong, the new position next week will be wrong, too. Say,
assignment is anticipated but fails to occur; the investor won't discover the unintended net
short stock position until the following Monday, and is subject to an adverse rise in the stock
over the weekend. Now assume the investor bet against assignment and bought the stock in
the market to liquidate the position. Come Monday, if assignment occurred after all, the
investor has bought the same shares twice, for a net long stock position and exposure to a
decline in the stock price.

Advantages of a Bear Put Spread

The main advantage of a bear put spread is that the net risk of the trade is reduced. Selling the
put option with the lower strike price helps offset the cost of purchasing the put option with
the higher strike price. Therefore, the net outlay of capital is lower than buying a single put
outright. And it carries far less risk than shorting the stock or security since the risk is limited
to the net cost of the bear put spread. Selling a stock short theoretically has unlimited risk if
the stock moves higher.

If the trader believes the underlying stock or security will fall by a limited amount between
the trade date and the expiration date then a bear put spread could be an ideal play. However,
if the underlying stock or security falls by a greater amount then the trader gives up the
ability to claim that additional profit. It is the trade-off between risk and potential reward that
is appealing to many traders. With the example above, the profit from the bear put spread
maxes out if the underlying security closes at $30—the lower strike price—at expiration. If it
closes below $30 there will not be any additional profit. If it closes between the two strike
prices there will be a reduced profit. And if it closes above the higher strike price—$35—
there will be a loss of the entire amount spent to buy the spread.

Risks

 The trader runs the risk of losing the entire premium paid for the put spread if the
stock does not decline.

 As the bear put spread is a debit spread, time in not on the trader’s side, as this
strategy only has a finite amount of time before it expires.

 There is a possibility of an assignment mismatch if the stock declines sharply; in this

case, since the short put may be well in the money, the trader may be assigned the
stock. While the long put can be exercised to sell the stock in the event of assignment,
there may be a difference of a day or two in settling these trades.

 Since profit is limited with a bear put spread, this is not the optimal strategy if a stock
is expected to decline sharply. In the previous example, if the underlying stock fell to
$40, a trader who was very bearish and therefore had only purchased the $50 puts
would make a gross gain of $10 on a $2.50 investment for a return of 300%, as
opposed to the maximum gross gain of $5 on the $1.50 investment in the put spread, a
return of 233%.

Profiting from a Bear Put Spread

Since a bear put spread involves a net cost or debit, the maximum loss that can arise from this
strategy is the cost of the trade plus commissions. The maximum gain that can be made is the
difference between the strike prices of the puts (less commissions, of course). This risk-
reward profile means that the bear put spread should be considered in the following trading
situations:
 Moderate downside is expected: This strategy is ideal when the trader or investor
expects moderate downside in a stock, rather than a precipitous decline in it. If the
trader expected the stock to plunge, standalone puts would be the preferred strategy in
order to derive the maximum profit, since profits are capped in a bear put spread.

 Risk is sought to be limited: As this is a debit spread, the strategy’s risk is limited to
the cost of the spread. The bear put spread also has a significantly lower degree of risk
than a naked (or uncovered) short sale.

 Puts are pricey: If puts are relatively expensive - typically because of high implied
volatility - a bear put spread is preferable to buying standalone puts, since the cash
inflow from the short put will defray the price of the long put.

 Leverage is desired: For a given amount of investment capital, the trader can get more
leverage with the bear put spread than by short-selling the stock.

Example

Let’s say you are a new options trader and want to make an impression on your
seasoned colleagues. You identify Flax Net (a hypothetical stock, we might add) as a
candidate for a bearish option trade. Flax Net is trading at $50, and you believe it has
downside risk to $45 over the next month. Since implied volatility in the stock is quite
high, you decide that a bear put spread is preferable to buying standalone puts. You
therefore execute the following bear put spread:

Buy five contracts of $50 Flax Net puts expiring in one month and trading at
$2.50.Sell five contracts of $45 Flax Net puts also expiring in one month, and trading
at $1.00. Since each option contract represents 100 shares, your net premium outlay is
=($2.50 x 100 x 5) – ($1.00 x 100 x 5) = $750.

Consider the possible scenarios a month from now, in the final minutes of trading on
the option expiration date:
Scenario 1: Your bearish view proves to be correct, and Flax Net tumbles to $42.

In this case, the $50 and $45 puts are both in the money, by $8 and $3 respectively.

Your gain on the spread is therefore: [($8 - $3) x 100 x 5] less [the initial outlay of $750]

= $2,500 – $750 = $1,750 (less commissions).

The maximum gain on a bear put spread is realized if the stock closes at or below the strike
price of the shot put.

Scenario 2: Flax Net declines, but only to $48.50.

In this case, the $50 put is in the money by $1.50, but the $45 put is out of the money and
therefore worthless.

Your return on the spread is therefore: [($1.50 - $0) x 100 x 5] less [the initial outlay of $750]

= $750 – $750 = $0.

You therefore break even on the trade, but are out of pocket to the extent of the commissions
paid.

Scenario 3: Flax Net goes in the opposite direction to the one you had anticipated, and rises
to $55.

In this case, the $50 and $45 puts are both out of the money, and therefore worthless.

Your return on the spread is therefore: [$0] less [the initial outlay of $750] = -$750.

In this scenario, since the stock closed above the strike price of the long put, you lose the
entire amount invested in the spread (plus commissions).

In a Down Market, Bear Put Spreads Can Be Profitable

We normally expect our stocks to increase in value, not decrease. That's why the last few
years have seemed anything but normal -- and why you should be familiar with a strategy
known as a bear put spread.

As the name implies, this is a put used when you're bearish on a stock. Whether you expect a
specific stock or most stocks to be heading south, a bear put spread can come in handy. And
even if you're neutral or even slightly bullish on a stock, the returns from a bear put spread
can be attractive.

Finally, as a method of diversification, you might want to use a low-cost bear put spread as
protection against other more bullish positions on a particular stock.

How to Construct a Bear Put Spread

The bear put spread is constructed by purchasing a put and then selling another put with a
lower strike price, but with the same month of expiration. This will result in a debit trade
(money will come out of your account to enter the trade), and this debit will be the maximum
loss that you can incur in the trade.

At first glance, this may appear to be a case of buying high and selling low. However,
because the put actually increases in value as the stock price drops, you're creating a trade in
which you're actually buying at the low price and, if the stock falls in value, the bear put
spread will increase in value.

Stocks tend to fall in value faster than they go up, so the bear put spread is generally a short-
term trade. Therefore you'd want to put the trade on with less than 45 to 60 days before
expiration. In addition, you'd want a stock that has some further room to fall, not one that is
bouncing against a price of zero. You would generally want a stock with a price of at least
$15 to $20, the higher the better.

The maximum profit on a bear put spread is calculated as follows: the difference in strike
prices of the long and short puts less the net debit, times the value per point ($100 in the case
of stock options), times the number of spreads purchased.

The maximum loss of the trade at expiration is simply the net debit of the trade times the
value per point ($100 in the case of stock options) times the number of contracts.

Example in the Pharmaceuticals Industry

If you are looking for a bearish trade, you first need a stock that you believe will actually lose
value over the next period of time. Of course, the best place to look for downward-trending
stocks is among those sectors that have a downward bias already.

One such sector that has been falling in value recently is the drug sector, and within that
sector is a company called Idec Pharmaceuticals ( IDPH). On Thursday, June 20, the stock
closed at $33.98, down almost 50% over the past three months. On its price and volume
chart, you'll see it has a nice, strong, downward trend on increasing volume. As the stock is
trading at $34, there's certainly room for it to have a further downward move.

Idec's focus is targeted therapies for the treatment of cancer and autoimmune and
inflammatory diseases. It has a joint business arrangement with Genentech ( DNA). Sales
were $79.7 million for the quarter ended March 31, and net income was almost $30 million in
the same period. This is not a fly-by-night drug company, but rather one that is small,
dependent on only two drugs, and being pulled down with the general market meltdown in
the drug industry.

After deciding that this is a good candidate for a bear put spread, you then must estimate how
far down the stock is likely to fall in the next 30 to 60 days. This will determine just which
bear put spread (or spreads) you might look at. If you believe Idec can easily fall to $25 by
July's expiration, then you can look at the available options for a bear put spread. From the
CBOE Web site, the options and their associated prices are given in Table 1:

Source: Optionetics.com

From these options, you can actually construct six bear put spreads. Here are the various bear
put spreads in descending order of break-even (one measure of increasing risk).
Source: Optionetics.com

Theoretically, you would now select one to trade. If you're very conservative, you'd choose
the July 40/35 put spread, where you would purchase the 02 Jul 40 put and sell the 02 Jul 35
put for a net debit of $3.80 per share, or $380 per spread. This would give you a 32%
maximum profit, which comes if the stock closes at or below $35 on July 19. Because the
stock was recently selling just under $34 a share, you're already at the maximum profit point.
In fact, the stock could actually increase by $1 and you would still garner the maximum profit
on this trade! The underlying stock could increase almost $2.25 (7%), and you would still be
profitable.
On the other hand, if you wanted to swing for the fences and were willing to take the most
risk, you could enter the Jul 30/25 put spread for $115 per spread. This bear put spread has a
potential profit of $385 per spread (335%) if Idec were to fall below $25 by July 19. In this
particular trade, the stock must fall $9 per share (26%) in the next four weeks to make the
maximum profit, and in fact, it must fall more than $5 just to break even. Of course, the other
four trades fall somewhere in between these two extremes.
Which trade should you choose? Depending on your belief in the weakness of the stock price
and your tolerance for risk, you could choose the Jul 30/25 bear put spread and pull in a
spectacular 335% return in just one month if you are correct in how far and how fast Idec will
fall. However, the much less risky position (Jul 40/35 bear put spread) is no slouch either.
The stock can actually increase in value by $1, and you would still get the maximum return
(32%) on the trade. If you could do this every month, 32% compounded monthly would
result in an original $3,800 (10 original contracts) growing to more than $10,600. Of course,
this doesn't account for commissions and taxes, but even so, the returns would sure beat the
average (or even above-average) mutual fund.

Exit Criteria

These trades are generally designed to go until expiration. Even if the stock moves
significantly in the first few days of the trade, the time value in the options will generally be
so high, and the slippage between the bid and ask prices so great, that there is little, if any,
increase in the value of the spread. However, this can actually be used to your advantage. If
the stock moves sharply against you, especially early on in the trade, you can usually exit the
position (buy back the short put and sell the long put) without too much of a loss.

The basic exit criteria are as follows:

 If the stock moves sharply one direction or the other early in the trade:

A. If the stock moves sharply down in price early in the trade, look at the net price of the
spread and exit it if you have roughly 70% to 80% of your expected profit. In this
trade, you would be looking to make about 85 cents per share, or be able to sell the
spread for $4.65 or more. As you spent $3.80 to enter the trade, you would be exiting
with a 22% profit, and not risking losing it all by an equally sharp run-up in the last
days of the spread.

B. If the stock moves sharply up in price early in the trade, exit the position as soon as
possible. Obviously the stock is not doing what you expected it to do, and hence you
should get out. Waiting will only increase your losses, up to the maximum of your
debit.

As you approach expiration day:

A. If the stock has moved below the short put, buy back the short put and sell the long
put for 80% of the maximum profit or more. The closer you are to expiration, the
more of the profit you will capture.

B. If the stock is between the short and the long puts, you must decide just when to exit.
If you wait until closing on expiration day, you can simply let the short put expire
worthless and sell the long put. That will save you one commission and one bid/ask
spread slippage. As long as the stock price is below the break-even price, you will
make a profit. As the stock price closes above break even, you will lose more and
more money up to the maximum of the debit of the trade -- when the stock price is at
or above the strike price of the long put.

C. If the stock price is right at or slightly above the strike price of the long put, you are in
the maximum loss position.

You can:

I. Let both options expire worthless, taking the full loss of the debit.
 II. Sell the long put (going naked, of course, on the short put for a day or so) if there is
any time value left in the long put. This, of course, is quite risky due to the naked
short put.

III. Exit the entire position, selling the long put and buying back the short put.

IV. Morph the trade into a bull put spread by selling the long put and purchasing a put
with a strike below the strike of your original short put for a net credit. This will
often work if the stock hasn't moved too far above the strike of the long put, if your
outlook for the stock has switched from bearish to bullish, and if there is still some
time left (several days to a week) before expiration.

The Greeks

The bear put spread tends to minimize the effects of the so-called Greeks on the trade.
Because you are both buying and selling premium, the tendency is for the impact of the
Greeks on a trade to be basically, though not totally, neutralized.

Delta (rate of change): Delta, or the rate of change of the option price with a small price
change in the underlying, will be almost neutralized by the spread. Because you are both long
and short a put, and the puts are relatively close together, there will be almost as many
positive as negative deltas in your position. This is primarily why the trade doesn't move
much with daily price changes of the underlying. For instance, in this trade the long put (02
July 40 put) has a delta of -74.330, while the short put (02 Jul 35 put) has a positive delta of
+49.705. Netting the position, you get a net delta of -24.625: not exactly delta neutral, but
two-thirds closer than if you simply purchased the put.

Theta (time decay): Time decay is both working against you (the long put) and for you (the
short put). The resulting combination will depend on just which options you buy and which
options you sell. If you recall the bell-shaped curve of time value around the at-the-money
(ATM) options, you will recognize that there will be more time value in options ATM and
less in options that are either in the money (ITM) or out of the money (OTM). As you are
buying a slightly ITM put and selling one that is close to ATM, time value will actually be
working just slightly in your favor in this particular example. However, a different selection
(say, the 02 Jul 30/25 bear put spread, for instance) would have time value working slightly
against you.
Vega (volatility): As with theta, you are both buying and selling volatility. Unless there is a
significant skew around the monthly options, you will be buying and selling about the same
amount of volatility. Thus, the bear put spread will be relatively insensitive to small
movements in the price of the underlying. This is both good and bad. It is good in that your
position will not bounce all over the map with every price change of the stock. This will help
in entering and exiting the position, in that a net price for the spread, once determined, will
not change much in its value over the following few minutes, regardless of the fluctuations in
the stock price. On the other hand, a quick drop in the stock price may not make much of a
corresponding run-up in the net value of the spread. Thus, you'd need to hold the position
until it gets close to expiration, or the stock must move really significantly for you to prosper.