Bear (Long) Put Spread

Posted by A Mahendra in Advanced Strategies on March 3rd, 2010 | no responses

A bear put spread is a fundamental bearish spread in options trading, composed of two put options with different strike prices that expire in the same month, where a “HIGHER” put strike is purchased and a “LOWER” put strike is sold, simultaneously. Think of the basic definition of buying a put option and selling a put option to understand how the spread would function!!

By buying a “higher strike” put option, you gain the “right” to sell shares of an underlying at a given price and by selling a “lower strike” put option; you undertake an “obligation” to accept (buy) those same shares at a lower price. This is very similar to shorting stock, where you sell shares at a higher price and then buy them back a lower price, booking the difference as a profit. Therefore, the most you can make on a bear (long) put spread is the difference between the two strikes. Maximum Value of Spread = Difference between Strike Prices

By combining a long put option with a short put option, you will be able to create a bear put spread, also referred to as a long (buying) put spread. This type of spread is placed for a debit, thus the term “long” put spread. Take a look at the risk profile below for further clarification:

Now that you understand how a bear put spread functions, let’s look at an example. Let’s say that you are bearish on Research in Motion (RIMM) and after looking at RIMMs option chain, you decide that buying a straight put is too expensive (65 strike would cost $1.97), thus you decide to buy a put spread instead. Your expectation is that RIMM will drop to $60 within the next 5 weeks, so you decide to buy a 65 put and sell a 60 put simultaneously, creating a bear (long) put spread.

The 65 put will cost a debit of $1.97, while the 60 put will bring in a credit of $0.94. Combining the two put options together would create a bear put spread, which would cost a net debit of $1.03. Since the spread can be worth only $5 (difference between strikes), the most you could make on this trade would be $5 – $1.03 = $3.97, at expiration.

Basically, you would be risking a debit of $1.03 (max loss) to make $3.97 (max profit). Max. Risk (Loss) = Debit Paid

Max. Profit = Difference between Strike Prices – Debit Paid

Before placing this type of trade, you must analyze the likelihood of RIMM dropping all the way from $72 to $60. Otherwise, you could always analyze the 70/65 put spread, which would cost you a net debit of $1.89. Trading options is all about balancing your risk with the expected reward and your analysis of the underlying stock.

The 65/60 bear put spread would breakeven once the debit paid ($1.03) to enter the trade is recovered. In this case, your breakeven would be $65 – $1.03 = $63.97. At expiration, RIMM would have to drop to $63.97 before the 65/60 put spread would start to make money.

Breakeven = Long Put Strike – Debit Paid to enter spread

Now that we know how a bear put spread functions, let’s look at the several advantages of this strategy: