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Establishing a bear put spread involves the purchase of a put option on a particular
underlying stock, while simultaneously writing a put option on the same underlying
stock with the same expiration month, but with a lower strike price. Both the buy and the
sell sides of this spread are opening transactions, and are always the same number
of contracts. This spread is sometimes more broadly categorized as a "vertical spread":
a family of spreads involving options of the same stock, same expiration month, but
different strike prices. They can be created with either all calls or all puts, and be bullish
or bearish. The bear put spread, as any spread, can be executed as a "package" in one single
transaction, not as separate buy and sell transactions. For this bearish vertical spread,
a bid and offer for the whole package can be requested through your brokerage firm from
an exchange where the options are listed and traded.
MARKET OPINION: Moderately bearish to bearish.
Moderately Bearish
An investor often employs the bear put spread in moderately bearish market
environments, and wants to capitalize on a modest decrease in price of the underlying
stock. If the investor's opinion is very bearish on a stock it will generally prove more profitable
to make a simple put purchase.
Risk Reduction
An investor will also turn to this spread when there is discomfort with
either the cost of purchasing and holding the long put alone, or with the conviction of his
bearish market opinion.
The bear put spread can be considered a doubly hedged strategy. The price
paid for the put with the higher strike price is partially offset by the premium received
from writing the put with a lower strike price. Thus, the investor's investment in the long put
and the risk of losing the entire premium paid for it, is reduced or hedged.
On the other hand, the long put with the higher strike price caps or hedges
the financial risk of the written put with the lower strike price. If the investor is assigned
an exercise notice on the written put, and must purchase an equivalent number of underlying
shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace.
The premium received from the put's sale can partially offset the cost of purchasing
the shares from the assignment. The net cost to the investor will generally be a price less
than current market prices. As a trade-off for the hedge it offers, this written put limits the potential
maximum profit for the strategy.
Downside Maximum Profit:
Limited
Difference Between Strike Prices - Net Debit Paid
Maximum Loss: Limited
Net Debit Paid
A bear put spread tends to be profitable if the underlying stock decreases
in price. It can be established in one transaction, but always at a debit (net cash outflow).
The put with the higher strike price will always be purchased at a price greater than the offsetting
premium received from writing the put with the lower strike price.
Maximum loss for this spread will generally occur as underlying stock price rises
above the higher strike price. If both options expire out-of-the-money with no value, the
entire net debit paid for the spread will be lost.
The maximum profit for this spread will generally occur as the underlying
stock price declines below the lower strike price, and both options expire in-the-money. This
will be the case no matter how low the underlying stock has declined in price. If the underlying
stock is in between the strike prices when the puts expire, the purchased put will be in-the-money,
and be worth its intrinsic value. The written put will be out-of-the-money, and have no
value.
BEP:
Strike Price of Purchased Put - Net Debit Paid
Volatility Increases: Effect Varies
Volatility Decreases: Effect Varies
The effect of an increase or decrease in either the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect
on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money,
and the time remaining until expiration.
Passage of Time: Effect Varies
The effect of time decay on this strategy
varies with the underlying stock's price level in
relation to the strike prices of the long and short options. If the stock
price is midway between the strike prices, the effect can be minimal. If the stock price
is closer to the higher strike price of the purchased put, losses generally increase at a faster
rate as time passes. Alternatively, if the underlying stock price is closer
to the lower strike price of the written put, profits generally increase at a faster rate as time passes.
A bear put spread purchased as a unit for a net debit in one transaction
can be sold as a unit in one transaction in the options marketplace for a credit, if it
has value. This is generally the manner in which investors close out a spread before its options expire,
in order to cut a loss or realize profit.
If both options have value, investors will generally close out a spread in
the marketplace as the options expire. This will be less expensive than incurring the commissions
and transaction costs from a transfer of stock resulting from either an exercise of and/or
an assignment on the puts. If only the purchased put is in-the-money and has value as it expires,
the investor can sell it in the market place before the close of the market on the option's last trading
day. On the other hand, the investor can exercise the put and either sell an equivalent number of shares that he
owns or establish a short stock position.
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