Updated: Nov 29, 2020
BEAR PUT SPREAD
Strategy Type : Moderately bearish
# of legs : 2 (Long ATM Put + Short OTM Put)
Maximum Reward : (Strike price of longPut - Strike price of short Put) - (Premium of long Put - Premium of short Put)
Maximum Risk : Premium of long Put - Premium of short Put
Breakeven Price : Strike price of long Put-(Premium of long Put- Premium of short Put)
Payoff Calculation : Payoff of Long Put+ Payoff of Short Put
Explanation of the Strategy
A Bear Put Spread is an option strategy wherein the trader would buy an ATM or slightly OTM Put option and simultaneously sell an OTM Put option on the same underlying instrument and having the same expiration. Because this strategy involves buying a higher strike Put and selling a lower strike Put, this is a moderately bearish strategy. The lower strike Put option that is sold reduces the overall cost of the transaction, but this comes at a price: the maximum profit gets capped at the lower strike price. Compare this strategy to a naked long Put. An advantage of Bear Put Spread over a naked long Put is that the former costs less. On the other side, a disadvantage of Bear Put Spread over a naked long Put is that the former limits the profit potential at the lower strike while the latter does not restrict the profit potential. Hence, whether to initiate a Bear Put Spread or a naked long Put depends completely on the view as well as on the risk profile of the trader.
This strategy not only has a limited profit potential, but it also has a limited loss potential. The maximum that the trader stands to lose is the net premium that he/she has paid on this strategy. This occurs when the underlying price trades at or above the higher strike price. So, while the lower strike restricts the profit potential, the higher strike restricts the loss potential. In between these two is the breakeven price, which is the point of no profit and no loss. The position is profitable when the underlying price is below the breakeven price and loss-making when the underlying price is above the breakeven price.
Benefits of the Strategy
· Maximum loss is limited to the extent of net premium paid
· Shorting an OTM Put reduces the overall cost of the strategy
· The breakeven point of this strategy is smaller as compared to that of a naked long Put.
Drawbacks of the Strategy
· Put that is sold at the lower strike limits the maximum profit that can be earned
· Because this is a net debit strategy, the trader will lose money even if the underlying consolidates
· If the underlying price is above the breakeven price as expiration approaches, Theta would work against the trader
· Ensure that price of the underlying is trending lower and is below a resistance level that looks difficult to crack in the near-term
· Ensure that the options you are transacting are not closer to expiry and there is decent time left for the strategy to work out in your favour
· While the strike price of the long Put will be either ATM or slightly OTM, be realistic when selecting the strike price of the short Put
· Remember, you would want the underlying price to drop to the lower strike price, in order to maximize the profit potential of the strategy
· Remember that the difference between the two strikes will be a trade off between risk/reward and the net cost of the strategy
· If the underlying price declines to the lower strike price and if the outlook continues to look bearish, one could consider closing out the existing short Put and either write a new Put at an even lower strike or just let the long Put run in isolation
· Ensure that there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Bear Put Spread
GreekValue is Notes Delta Negative: The overall Delta is negative at initiation. As a result, the position stands to benefit when the underlying price falls, and vice versa.
GammaPositive :At initiation, the position Gamma is positive, causing the position Delta to rise (i.e. become less negative) as the underlying price rises, and vice versa. However, when the underlying price isbelow the breakeven price, the position Gamma is negative, which causes the position Delta to fall (i.e. become more negative) for a given rise in the underlying price, and vice versa.
VegaPositive : At initiation,the overall Vega is positive, meaning volatilityhelps the position as long as the underlying price is above the breakeven price. Once the underlying price moves below the breakeven price, Vega turns negative, meaning volatility will start hurting the position.
ThetaNegative : The overall Theta is negative at initiation, meaning time decay hurts the position. However, when the underlying price is below the breakeven price, Theta is positive, meaning time decay benefits the position.
RhoNegative: The overall Rho is negative at initiation. As a result, rising interest rates hurt the position, and vice versa. However, it must be noted that this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Bear Put Spread
The chart below is the payoff chart of a Bear Put Spread strategy. Observe that the payoff structure of this strategy is quite similar to that of a Bear Call Spread. However, there are differences between the two. The most notable difference is that while a Bear Call Spread is a net credit strategy, a Bear Put Spread is a net debit strategy. As a result, there is cash inflow into your trading account when you execute a Bear Call Spread and a cash outflow from your trading account when you execute a Bear Put Spread.
It can be seen from the above chart that as long as the underlying price is above the higher strike price, the position will be suffer maximum loss. This maximum loss will be limited to the extent of net premium paid, no matter how higher the underlying price goes above the higher strike price. The quantum of loss reduces when the underlying price is between the higher strike price and the breakeven price. And once the underlying price falls below the breakeven price, the position starts making money, until the underlying price reaches the lower strike price, at which the maximum profit gets capped. No matter how lower the underlying price drops below the lower strike price, the trader will not earn anything in excess. Hence, Bear Put Spread is a limited profit, limited loss strategy. The gains/losses are made when the underlying price is in between the two strikes and flattens out when the underlying price moves beyond the two strikes.
Example of Bear Put Spread
Let us say that Mr. ABC has analysed the chart of Nifty and has concluded that the index will drop 4-5% in the short-term from the current levels. Besides, ABC has also concluded that the index is unlikely to drop any further and is likely to maintain a moderately negative tone in the short-term. Based on this, ABC decides to initiate a Bear Put Spread strategy, wherein he will buy 1 ATM 8250 Put at the prevailing price of ₹555 and simultaneously sell 1 OTM 7900 Put at the prevailing price of ₹460. Let us summarize the details of the strategy below:
· Strike price of long Put = 8250
· Strike price of short Put = 7900
· Long Put premium = ₹555
· Short Put premium = ₹460
· Net Debit = ₹95 (555 - 460)
· Net Debit (in value terms) = ₹7,125 (95 * 75)
· Breakeven price of the strategy = ₹8,155 (8250 - 95)
· Maximum Potential Loss = ₹7,125
· Maximum Potential Profit = ₹19,125 ((8250 - 7900 - 95) * 75)