A bear put spread is a strategic play for investors expecting a moderate-to-large decline in the price of an asset. This options strategy is designed to minimize the cost of holding the trade while providing profit potential.
What is a Bear Put Spread?
A bear put spread involves buying put options while simultaneously selling an equal number of put options on the same asset with the same expiration but at a lower strike price. This strategy limits both potential profit and loss, making it an attractive choice for conservative traders.
A put option grants the holder the right—but not the obligation—to sell a specified quantity of an underlying asset at a predetermined price, known as the strike price, on or before the option’s expiration date. The bear put spread strategy is also called a debit put spread or a long put spread.
Key Takeaways
- A bear put spread is aimed at capitalizing on declining asset prices while reducing investment risk.
- This strategy entails the simultaneous purchase and sale of puts on the same underlying asset with differing strike prices but the same expiration date.
- Profit is realized when the underlying asset’s price declines.
The Mechanics of a Bear Put Spread
Example Scenario
Imagine a stock is trading at $30. To execute a bear put spread, a trader buys a put option contract with a $35 strike price for $475 (calculated as $4.75 x 100 shares/contract), and concurrently sells a put option contract with a $30 strike price for $175 ($1.75 x 100 shares/contract).
The net cost of the strategy is $300 ($475 - $175). If the asset’s price falls below $30 upon expiration, the trader can realize a maximum profit of $200. This profit is derived from the difference in strike prices ($35 - $30) x 100 shares/contract ($500) minus the net cost ($300), resulting in a profit of $200.
Advantages and Disadvantages of a Bear Put Spread
Pros
- Lower risk compared to short selling
- Suitable for moderately declining markets
- Limits losses to the net cost of the options
Cons
- Potential risk of early assignment
- Risk increases if the asset’s price rises sharply
- Limits potential profit to the difference in strike prices
Trade-Offs
The bear put spread has its maximum profit potential when the asset closes at or below the lower strike price. If the asset’s price closes between the two strike prices, a partial profit is realized. Should it close above the higher strike price, the entire amount invested is lost.
There’s also the potential for early assignment, meaning one may have to fulfill the trade obligation sooner than expected due to factors like mergers or special dividends that notably affect the underlying stock.
Real-World Example of Bear Put Spread
Consider Levi Strauss & Co. (LEVI) trading at $50 on October 20. Anticipating a modest drop in the stock price, you buy a $40 put for $4 and sell a $30 put for $1, both expiring on November 20. Your net cost for this trade is $3 ($4 - $1).
If the stock price closes above $40, your maximum loss is $3. If it drops to $30 or below, your maximum gain is $7, calculated as a $10 difference in strike price minus your $3 net cost. Your break-even price is $37, which accounts for the higher strike price minus the net cost.
Related Terms: short selling, strike price, expiration date, underlying asset, long put spread.
