Vertical Option Spreads – Bear Put Spread

by Josip Causic | December 10, 2009 12:03 pm

 

This article originally appeared on The Options Insider Web site[1]. 

In the final installment of my five-part series on vertical spreads[2], I’m going to explain the last of the four possible vertical spreads: the bear put.

The bear put strategy has many different names, including long vertical put spread, vertical debit put and a vertical put buy.

Bear Put vs. Bull Call

A bear put and a bull call[3] are sister strategies because they are both debit verticals[4]. The main difference between the two vertical debit strategies is market outlook. Their respective adjectives (bear in the bear put and bull in the bull call) reflect the direction of the strategy.

A bear put spread is a strategy which can be used when:

1. Market conditions are somewhat neutral to bearish
2. The implied volatility[5] of the underlying is low or in its lower range

Buying a vertical debit spread is very suitable for the environment that we are currently in.

When it comes to a bearish outlook, the trader does have a choice to purchase the long put if he or she feels a strong bearish bias; however, if the bias is slightly less bearish, or as I mentioned above, neutral to bearish, then putting on a vertical debit put (bear put) gives you a slight discount when compared to the long put.

Bear Puts: The Basics

The basics of a bear put involve first buying a put and then selling a put with a lower strike on the same underlying and in the same month of expiry. The strategy always produces a debit to our account because the higher-strike put ALWAYS costs more than the lower-strike put. The maximum profit potential is achieved if the stock or the underlying trends down below the lower strike put.

Let’s look at a specific theoretical example. Say an issue is trading around $49 and the trader forecasts that it will drop and stay below $49 by expiry. A long option could be purchased (at the ask[6]) at a strike price that is higher than the current stock price, for example, at $50. Then the trader could short (at the bid) the put that is one strike price lower than the current stock price, for instance, at $47.50. The visual depiction in the chart below illustrates my point.

To determine the net debit, the sold premium must be subtracted from the premium paid for the long put; $2.50 – $1 = $1.50.

The net debit is also the maximum loss that could be taken in the trade if the trade is held until the expiry.

The maximum profit, on the other hand, is calculated by subtracting the net debit from the width of spread. In our example, 2.50 is the spread width (50 put – 47.50 put), so the max profit is $1 ($2.50 – $1.50).

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Unlike the credit spread[7], the money immediately departs from the trader’s account at the moment the spread gets filled.

The goal of the bear put is to have both options become in the money (ITM) by expiry. In other words, we should be aiming to get the highest premium possible in the shortest possible time. The maximum profit might not be attainable, so if we are able to take off the spread earlier and keep the majority of the maximum profit, then we have done well as an option spread trader.

However, if the stock goes up, then the spread needs to be closed. The spread could still be mildly profitable or just breakeven, depending on how fast we acted. Exiting early prevents suffering the maximum loss, which could be substantial.

For novice option traders, it is difficult to exit a losing trade early due to the belief that right after they exit, the stock might do exactly what they had anticipated. When the underlying goes against you, even though exiting does not provide a profit, it does minimize the loss. (Learn how to effectively plan your exits[8].)

Approaching Expiration

Brokerage firms DO send out reminders in the last week prior to expiry to costumers who are holding options that are about to expire. If the trader does choose to hold onto the vertical debit put until the last minute, then it is certain that he or she will receive an e-mail from the broker. At no point should the trader assume that if both options are in the money that they won’t be assigned on their short ITM put.

If the trade is held until the last day and the options are about to expire ITM, then we need to act. The short leg being ITM at expiry could generate assignment, for the initial put sale gives the trader that obligation if the buyer chooses to exercise their put.

In our case, the opening trade was buy to open (BTO) + 50 put @ $2.50 and sell to open (STO) – 47.50 put @ $1. If it hasn’t been done as of that last day, now we must reverse these to close the spread: sell to close (STC) – 50 put and buy to close (BTC) + 47.50 put.

If you missed any of the earlier articles in my series on vertical spreads, you can check them out here:

• Vertical Option Spreads 101[9]
• When to Use a Bear Call Spread[10]
• How and When a Bull Put Spread Works[11]
• How to Trade a Bull Call Spread[12] 

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Source URL: https://investorplace.com/2009/12/vertical-options-spreads-bear-put-spreads/

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