Bear Put Spread
A trader uses this strategy when they believe the price of the stock will decrease in an alotted time frame. To conduct this trade you will buy one put that is “in” the money and simultaneously sell a put that is “out” of the money. Remember both options must be on the SAME underlying stock with the SAME expiration date. This trade limits our risk because we are selling an “out” the money put and therefore limits our potential profit. I will explain in more detail in a moment.
- When you buy the “in” the money put you are required to pay the premium upfront.
- When you sell the “out” of the money put you will receive a premium upfront.
- This combination lowers your total out of pocket expense significantly.
This strategy will require you to enter the trade on a debit. In short you will be required to pay money upfront, but remember because we sold an “out” of the money put you are paying significantly less than you would if you just purchased the put outright.
Bad News: If the underlying price of the stock rises above the strike price of the put you bought “in” the money. Then your prediction did not come to fruition and you will take a loss.
Less Bad News: The loss loss you will incur is only the initial amount you paid to enter the trade. That’s it! Of course we never want to lose money but when you sell the “out” of the money put you significantly decrease your out of pocket expense.
Limited Profit Potential:
Good News: If the underlying price of the stock falls below the strike price of the put you sold “out” of the money. Then your prediction and analysis was correct and you will receive a profit.
Even Better News: The profit you will receive is the difference between the two strike prices of the options you bought and sold minus the debit you paid to enter the trade.
Ok whew!! I know that was a lot and more technical than I would have liked but it was necessary. Let’s take a look at a real world example. I like showing examples because I am more of a visual learner myself!
Real World Example:
You see that MSFT is currently trading at $27.25 and you believe that by March 15, 2013 it will be trading for less than $27/share.
You decide to execute a bear put spread trade by buying the “in” the money March $28 (strike price) Put for $141 (remember options are 100 share lots) and selling the “out” of the money March $27 (strike price) Put for $82. This would bring your net debit price to $59. Not bad!
Good: On March 15, 2013 the price of MSFT is trading below $27. Since the difference between the strike prices are $1 you will receive $100 for each contract MINUS the debit we paid. So in this case we would receive $100 – $59 for a $41 profit.
So So: On March 15, 2013 the price of MSFT is trading between $27 & $28. Since the price is above our “out” of the money put of $27 that option will expire worthless and we will keep the $82 premium we received when we entered the trade. The “in” the money put of $28 that we purchased will still have value so we would need to close that position and recoup whatever value is left. This is typically known as the “break even point.”
Bad: On March 15, 2013 the price of MSFT is trading above $28. Since the price is above both of your strike prices they will expire worthless and you would lose your initial investment of $59.
There you have it! I hope you have learned something and can add this to your trading arsenal.
Here’s to our Wealth!
Do you have experience with options spreads? If so, how were your results?