If you feel like opening a bearish trade is a good idea but don’t want to risk too much (as you would with a naked call, for instance), the bear put spread strategy might be for you. This options setup involves buying and selling put options at different strike prices, aiming to profit from a decline in the underlying asset while limiting potential losses. Let us answer the “what is a bear put spread strategy?” question (with the help of a real-life example) so you can better understand its dynamics and apply it to your trading.
Key takeaways
- A bear put spread strategy is an options setup used by bearish investors aiming to maximize gains while limiting potential losses.
- This debit put spread consists of simultaneously buying and selling put options on the same underlying asset with the same expiration date, but at varying strike prices.
- As a debit strategy, the bear put spread requires an initial capital outflow, but it also provides a defined risk profile.
What Is a Bear Put Spread Strategy?
A bear put spread strategy (also known as long put spread) is a way to bet on a decline in the underlying stock’s price while limiting risk. It involves buying one put option and selling another with the same expiration date but at a lower strike price. This combination creates a net debit position, meaning there’s an initial cash outlay.
In simpler terms, a bear put spread strategy involves purchasing a put option (a long put) with a higher strike price and simultaneously selling a put option (a short put) with a lower strike price. Both options have the same expiration date. The goal of the long put spread is to profit from a fall in the underlying stock’s price without taking on too much risk.
How Does the Bear Put Spread Strategy Work?
Here’s how it works:
- Initial Setup: Buy a put option at a higher strike price and sell a put option at a lower strike price.
- Cost: The strategy is also known as “debit put spread.” The net debit, in this case, is the difference between the price paid for the long put and the premium received from the short put.
- Profit Potential: Maximum profit occurs if the stock price falls below the lower strike price at expiration.
- Risk Management: The risk is limited to the initial net debit.
To illustrate, consider the profit and loss profile below:
The image above shows you the P&L you’d have in a bear put spread example where you buy a put option for $60 and sell another one for $55. If the net cost of this setup is $2 per share, your maximum loss is $2 per share. If the stock falls to $55 or below, your maximum gain would be the difference between the strike prices minus the net debit, which, in this case, is $3 per share.
Why Use the Bear Put Spread Strategy?
Investors use the bear put spread when they expect a moderate-to-large decline in the underlying stock but want to limit their exposure. Here are some scenarios where the bear put spread strategy might be useful:
- Market Downtrend: When investors anticipate a market downturn but want to avoid the risks associated with outright short-selling.
- Risk Management: The strategy allows investors to define their maximum loss upfront, making it less risky compared to other bearish strategies like naked calls.
- Cost Efficiency: By selling the lower strike put, the investor can offset part of the cost of buying the higher strike put, making the strategy more affordable.
A Bear Put Spread Example
If this is not your first time on this blog, you’ll know how much we like giving you examples for every option strategy we review. Let’s assume you have found a bear put spread opportunity on our options screener.
Specifically, you could focus on Chewy Inc (CHWY). Let’s say you notice that the company’s fundamentals are not that great (for instance, our fundamental score for Chewy Inc rates the company as 5 out of 10), and you think there is a good chance the stock price will go down.
At the same time, you also feel like, after several bearish days, a price rebound for CHWY cannot be ruled out. Therefore, you want to cap your losses. This is a good opportunity to test the bear put spread strategy.
With CHWY trading at $22.83, you could buy a $20.5 put and sell a $19.5 put, both expiring in 2 weeks. Here’s how this bear put spread example works:
Setup and P&L
- Buy one $20.5 put: This is your long put option.
- Sell one $19.5 put: This is your short put option.
Your P&L profile would look like this:
- Breakeven Point: Your breakeven point is $20.34. This means for you to break even, CHWY needs to fall to $20.34 by expiration.
- Maximum Profit: If CHWY drops below $19.5 by expiration, you’ll have a maximum profit of $84.25.
- Maximum Loss: If CHWY remains above $20.5, your maximum loss would be limited to $15.75.
Risk vs. Reward
The profit ratio of this trade can be tempting: 534.92%. However, this is not a free meal (while we’re at it, remember: there is no free meal in options trading), and a high profit ratio with a bear put spread can come with a relatively low chance of profit. So it’s up to you: yes, you may very well end up losing a little money, but this loss may justify the risk.
Key Points to Remember
- Profit Potential: Limited to the difference between strike prices minus the net debit.
- Risk: Capped at the initial net debit.
- Breakeven Point: Price where the stock needs to fall for you to break even.
This bear put spread strategy allows you to capitalize on a bearish outlook for CHWY while capping your potential losses, making it a controlled-risk play for uncertain market conditions.
Using Put Spreads in Different Ways: The Bear Put Spread vs the Short Put Spread
Depending on the way you trade your puts, you can use different spread strategies to suit your market outlook. Start by taking a look at the table below, which summarizes the main differences (and similarities) between the bear put spread and short put spread (We call it Bull put spread in the screener):
Bear Put Spread
A bear put spread strategy involves buying one put option (long put) and selling another with the same expiration but a lower strike price (short put). This setup results in a net debit, meaning it requires an initial cash outlay. The goal is to profit from a decline in the underlying stock while capping potential losses.
Short Put Spread
A short put spread, also known as bull put spread, is a credit spread strategy that involves buying one put option (long put) and selling another with the same expiration but a higher strike price (short put). This setup results in a net credit, meaning it generates cash upfront. The goal is to profit from an increase in the underlying stock while limiting potential losses.
Both strategies involve buying one put option and selling another with the same expiration, aiming to capitalize on a decline in the underlying stock’s price. The maximum loss is limited to the initial cash outlay or net credit received, depending on the strategy used. However, the bear put spread requires an initial cash outlay, while the short put spread generates cash upfront.
Pros and Cons of the Bear Put Spread Strategy
We certainly cannot wrap up this article without examining the pros and cons of the bear put spread strategy. The table below summarizes the advantages and disadvantages of the bear put spread strategy:
Pros
- Limited Risk: One of the most significant advantages of a bear put spread is its limited risk. Unlike short-selling, where potential losses can be unlimited, the risk with the debit put spread is capped at the initial net debit (cost) paid to set up the trade.
- Cost Efficiency: By selling the lower strike put, you reduce the overall cost of entering the position. This makes the bear put spread more cost-efficient compared to buying a long put outright. The premium received from the short put offsets some of the expenses incurred by purchasing the long put.
- Profit Potential: If the underlying stock declines moderately to significantly, the bear put spread strategy can offer substantial profit. The maximum profit is achieved if the stock price falls below the lower strike price at expiration.
Cons
- Limited Profit: The potential profit is capped at the difference between the strike prices minus the net debit. This means you won’t benefit from any additional decline in the stock price beyond the lower strike price.
- Time Decay: Time decay negatively impacts the value of the options as they approach expiration. Since you’re holding both a long and short put, time decay can erode your potential gains, especially if the stock doesn’t move as expected quickly enough.
- Assignment Risk: There is always the risk of early assignment on the short put option. This means you might be required to fulfill the obligation to buy the underlying asset at the short put’s strike price before the expiration date. Although rare, such early assignments can disrupt your original plan.
