In this video tutorial, we're going to talk about a bear put spread, one of the favorite strategies of some traders when they get started here once they learn how spreads work. Let’s get right into it here as always.
We're going to talk about the market outlook first for a bear put spread. It's employed when the trader thinks that the underlying price of the stock is going to go down moderately in the near term.
And I say moderately because what you’re doing with a bear put spread is you’re shorting an out of the money put which is going to reduce the cost of your bearish position. It’s going to reduce the cost of the trade, but it’s also going to cap your profits.
This is different than if you’re going to just outright buy a long put option in which case, you think there’s going to be a significant move down in the underlying stock. But here, you think there’s going to be a moderate move down, and you’re going to forego some of that large profit potential for a lower-cost strategy overall.
How you set this up is very easy. You’re going to buy a higher striking in the money put option and then you're going to sell a lower striking out of the money put option on the same underlying security and the same expiration date.
In this example, we’re going to buy one in the money put, in this case, it’s going to be a 40 strike put, and then we’re going to sell one out of the money put to help pay for some of the cost of buying that one put option.
You want to make sure that you make these spreads even whenever possible, so you want to sell and buy an even number of contracts. Now, this is different than back spreads, in which case, you’re going to add some extra contract.
Just check out one of those videos on put back spreads or call back spreads to understand what I’m talking about. What’s the risk? The maximum loss on these strategies is limited, so that’s the good thing.
The worst that can happen is that at expiration, the stock is higher or above the long put strike price, in which case, both options expire worthlessly, and you simply lose the money that you outlaid in the beginning.
Whatever the net debit or net cost of this trade was, that’s your maximum loss only if the stock closes higher than your long put strike price. Since this is a moderately bearish strategy, anything, where the market is rallying and is going to be bullish, is going to create a loss on this strategy.
The profit potential is also limited like we talked about earlier. The best that can happen is that the stock closes anywhere below your short strike price and that's going to be at 35.
In this case, you’d take in the full profit potential, but you are limited in your upside gains because you sold that option to help fund the purchase of the 40 strike put. Volatility for this particular strategy is going to be a little bit non-important or a non-factor overall.
Since you’re long an option and short an option, volatility is more or less going to offset each other to a large degree. Volatility is something that you don’t have to consider. It is going to make a big change as you start to get further out in your out of the money options.
As they get more out of the money, they’re going to be more susceptible to big changes in volatility, but for the most part, it’s not going to make that big of a difference if you keep your strike prices close.
The same thing with time decay in regards to this strategy, this put spread. Time decay is going to have a pretty low impact on the overall position. Since you’re long one option and short, the overall effects are going to offset each other.
Calculating the breakeven strategy on this particular profit loss diagram is fairly easy. What you’re going to do is you’re going to take the long put strike price which is down here at 40, and you’re going to subtract the debit that it cost you to enter this particular strategy.
You’re going to take a 40 and minus the $300 or $3 per contract, and that gets you a 37 which is where this strategy breaks even. You want to see the stock move at least down to 37, and then you’re going to have a net breakeven point on the strategy overall. Anything below that point and you start to make a profit.
Let’s take a look at a quick example here as we’re just talking about it. Say the stock price is at $37, so right here in our breakeven point. If you buy one 40 strike put, it’s going to cost you just that one option $400.
What you’re going to do is you’re going to sell one 35 strikes put for $100 and help fund the purchase of this long put. The net debit is still $300. You outlaid 400, and you took in a credit of 100 so that net debit is still $300 which you give up to the market for the right to own this strategy.
Your max loss is the $300. That's your strike price at 40 minus the credit. Your strike price at 40 here minus the $300 debit and that's going to create that $37 breakeven period, but your max loss is going to be the $300 in which you outlaid money for the strategy.
The maximum profit is what's left here. It's only the difference between your short strike at 35 and your breakeven point which is only $2 per contract or $200 credit. If the strategy or if the underlying stock trades anywhere below 35 by expiration, then your maximum profit is $200 on this position.
Some tips and tricks with this bear put spread. The strategy is a basic building block for more complex strategies. Like the put back spreads and call back spreads, this is something that you need to understand and master, how just two options can create different types of profit loss diagrams.
Remember, purchasing spreads that are slightly out of the money are best. That way, you don’t pay the high intrinsic value for the options. If the stock is trading at 37, you could even move the strikes out to 35 and 30 and purchase those options that are slightly out of the money.
Hedging can be a very easily achieved by purchasing an additional call option above 40 for short-term volatility moves. You can see on this strategy we're very exposed to higher prices that lead to a loss.
If we do anticipate short-term moves higher in the stock, but we still overall feel bearish, then what we can do is we can add one call option here at 40 and create more of a back spread. And that's going to be covered in other videos in our tutorial series as well.
But that’s an easy way to hedge your position against any moves in volatility or higher strike prices. As always, I hope you guys enjoy this video and thanks for watching. Please take just one second here and share this video with any of your friends, family or colleagues on your favorite social network.