Option Trades Can Profit in a Downward Market Use Bear Put Spreads
The bear put debit spread method is used when an option trader thinks the price of the underlying stock will go trend lower in the near term.
The bear put debit spread method is used when an option trader thinks the price of the underlying stock will go trend lower in the near term. The put debit spread strategy is also known as a bear put debit spread due to the fact that the option trader incurs a debit to enter the trade.
Like nearly all option trades involving spreads, the bear put debit spread consists of buying and selling two options. In this case, the option trader buys a higher striking – “in-the-money” - put option and sells a lower striking –“near-the-money” or “out-of-the-money” - put option of the same underlying security with the same expiration date.
Selling a "near-the-money" option tends to make a less risky, less profitable, put debit spread position. It is is considered a conservative approach. So, depending on your risk tolerance, use an NTM or OTM option to construct this option trade. As to risk, always keep in mind that 1 option contract is the equivalent of 100 shares of the underlying security. So trading 10 option contracts is equal to trading 1000 shares of the underlying stock.
Building a bear put debit spread is not difficult:
• Buy 1 “in-the-money” Put
• Sell 1 “near-the-money” or “out-of-the-money” Put.
Here is an example of a Bear Put Debit Spread in action:
Suppose XYZ stock is trading at $38 in June. An options trader who is bearish on XYZ stock can create a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for $100. This costs the option trader $200. That is to say, the option trader incurs a debit of $200 when he or she enters the trade.
Assume the price of XYZ stock subsequently drops to close at $34 at expiration. That means both puts expire “in-the-money.” With XYZ trading at $34, the JUL 40 Put will be worth $600 and the JUL 35 Put will be worth $100. The net value of the spread is $500.
The option trader’s net profit is $300. Five hundred dollars less the initial debit of $200 incurred to enter the trade.
If the stock advanced upward, instead of go down as the trader expected, both options could have expired “out-of-the money.” In that case, the options trader would have lost the opening debit of $200.
The initial debit of $200 (plus commissions paid) is always the upper limit of possible loss on a put debit spread.
Understanding the profit and loss formulas for the bear put spread strategy is not difficult:
The greatest profit is equal to the difference in strike price minus the debit incurred to get into the position:
• Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid - Commissions Paid.
Remember, the stock price needs to close below the strike price of the bought put on the date of expiration to gain maximum profit.
If the stock price closes above the bought put strike price at the expiration date, then the bear put spread strategy incurs the maximum loss, which is equal to the debit incurred when putting on the trade.
• Max Loss = Net Premium Paid + Commissions Paid.
Option trades can be designed to have a low risk breakeven point. This is a significant difference from stock trading where the breakeven is always equal to the cost of entering the position.
Calculate the breakeven point for a bear put debit spread as follows:
• Breakeven= Strike Price of Long Put - Net Premium Paid.
While we have use stocks as our example of this strategy, the bear put spread can be applied to ETF options, index options, and options on futures.
Traders are confronted with a variety of market conditions and need to know how to respond. The bear put spread is a strategy to consider when the market is moving lower.
The bear put debit spread method is used when an option trader thinks the price of the underlying stock will go trend lower in the near term. The put debit spread strategy is also known as a bear put debit spread due to the fact that the option trader incurs a debit to enter the trade.
Like nearly all option trades involving spreads, the bear put debit spread consists of buying and selling two options. In this case, the option trader buys a higher striking – “in-the-money” - put option and sells a lower striking –“near-the-money” or “out-of-the-money” - put option of the same underlying security with the same expiration date.
Selling a "near-the-money" option tends to make a less risky, less profitable, put debit spread position. It is is considered a conservative approach. So, depending on your risk tolerance, use an NTM or OTM option to construct this option trade. As to risk, always keep in mind that 1 option contract is the equivalent of 100 shares of the underlying security. So trading 10 option contracts is equal to trading 1000 shares of the underlying stock.
Building a bear put debit spread is not difficult:
• Buy 1 “in-the-money” Put
• Sell 1 “near-the-money” or “out-of-the-money” Put.
Here is an example of a Bear Put Debit Spread in action:
Suppose XYZ stock is trading at $38 in June. An options trader who is bearish on XYZ stock can create a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for $100. This costs the option trader $200. That is to say, the option trader incurs a debit of $200 when he or she enters the trade.
Assume the price of XYZ stock subsequently drops to close at $34 at expiration. That means both puts expire “in-the-money.” With XYZ trading at $34, the JUL 40 Put will be worth $600 and the JUL 35 Put will be worth $100. The net value of the spread is $500.
The option trader’s net profit is $300. Five hundred dollars less the initial debit of $200 incurred to enter the trade.
If the stock advanced upward, instead of go down as the trader expected, both options could have expired “out-of-the money.” In that case, the options trader would have lost the opening debit of $200.
The initial debit of $200 (plus commissions paid) is always the upper limit of possible loss on a put debit spread.
Understanding the profit and loss formulas for the bear put spread strategy is not difficult:
The greatest profit is equal to the difference in strike price minus the debit incurred to get into the position:
• Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid - Commissions Paid.
Remember, the stock price needs to close below the strike price of the bought put on the date of expiration to gain maximum profit.
If the stock price closes above the bought put strike price at the expiration date, then the bear put spread strategy incurs the maximum loss, which is equal to the debit incurred when putting on the trade.
• Max Loss = Net Premium Paid + Commissions Paid.
Option trades can be designed to have a low risk breakeven point. This is a significant difference from stock trading where the breakeven is always equal to the cost of entering the position.
Calculate the breakeven point for a bear put debit spread as follows:
• Breakeven= Strike Price of Long Put - Net Premium Paid.
While we have use stocks as our example of this strategy, the bear put spread can be applied to ETF options, index options, and options on futures.
Traders are confronted with a variety of market conditions and need to know how to respond. The bear put spread is a strategy to consider when the market is moving lower.
About the Author
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Ian Tai. Ian Tai is the author of this article on Option Trader. Find more information on Option Mentor here. |
