Bear Put Spread
The bear put spread is an example of a vertical debit spread strategy that is typically initiated when the investor expects a move lower in the underlying instrument. The trade is straightforward: buy a put and sell an equal number of lower strike puts. Writing the downside put reduces the cost of the trade and will hedge some of the risk associated with time decay.
While a bear put spread costs less than straight put buying, the trade-off is that there is limited downside profit potential because the investor is short the contract. If the lower strike put is in-the-money at expiration, assignment comes into play and the position has reached its max profitability. The best gain from a bear put spread is the difference between the two strikes minus the debit paid.
If, for example, SPY is trading at $138.50 and the investor expects a move to $133 or less through the January expiration, they can initiated a Jan 133 – 136 put spread for $1.50 by buying a Jan 133 put for $3 and selling Jan 130 puts put at $1.50. The spread, for a $1.50 debit, is a bearish play that will offer its best payoff if prices move to $133 or less by the expiration, which represents a market decline of about 4 percent. At that point, the spread is worth $3 (136 – 133) and the profit is $3 minus the debit paid, or $1.50.
On five spreads, the investor pays $750 and stands to make $750 if the market drops 4 percent. The breakeven at expiration is at $134.5 and equal to the higher strike put minus the debit. At that point, the $136 put is worth $1.50, the $133 put expires worthless, and there is no gain or loss on the trade. If SPY holds above $136 or better, the puts expire worthless and the debit is lost. The position can also be offset at any time by selling the Jan 133 – 136 put spread to close.
BEAR PUT SPREAD EXAMPLE: BUY 5 SPY Jan 133 – 136 Put Spreads for $1.50
Bias = Bearish
Breakeven = Higher strike put – debit: 136 – 1.5 = $134.50
Risk = Limited to the amount paid for the put spread: $1.50 X 5= $750
Reward = Spread minus debit: $3 – $1.50 = $1.50 X 5 contracts = $750