Bear Put Spreads:  An Alternative to Purchasing Puts

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy puts.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing puts is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here:  Options on Futures:  An Introduction to Buying Options.  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bear put spreads into your trading strategy.

What is a Bear Put Spread?

A bear put spread is a position that involves purchasing a put option on an underlying futures contract, while simultaneously writing a put option on the same underlying futures contract with the same expiration month, at a lower strike price.  As the name of the strategy hints, this is a position that is appropriate for a bearish market sentiment.

Why not just purchase a put?

This is one of the most common questions posed when a trader is first learning about bear put spreads.  Bear put spreads allow a trader to pay less premium to get involved in a position than simply purchasing a put.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a put that is closer to at-the-money.

How it works

As noted above, a bear put spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the put, but they also receive premium for selling a put as well.  For a bear put spread, a trader would typically purchase an at-the-money put and sell an out-of-the-money put to initiate a bear put spread.  The selling of the out-of-the-money put helps the trader finance the purchase of the at-the-money put.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Gary has a bearish sentiment on the crude oil market.  He decides the most cost effective way to get involved in the market is to enter a bear put spread.  Gary decides to get involved in July crude oil as it provides a reasonable time frame for the move he thinks will occur.  July crude oil futures are currently trading at 99.31.  Larry decides to enter a 99.00/90.00 bear put spread.  See below for the specifics on the options:

Purchase One July 99.00 Crude Oil Put Option for $3,920 (Pay)
Sell One July 90.00 Crude Oil Put Option for $1,130 (Collect)

Total Premium Paid for Position = $2,790 (3920 – 1130)

Gary’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$9,000 Difference in futures price (9*1000)
-2,790 Premium paid for call spread
$6,210 Maximum profit potential

Gary’s maximum risk is the $2,790 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July crude oil futures market is trading at under 90.00.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

• July 99.00 crude oil put expires on June 16th, the option is exercised and Gary’s account is short crude oil futures contract from 99.00.
• July 90.00 crude oil put expires on June 16th, assigning Larry’s account a long crude oil futures contract from 90.00.
• The short 99.00 July crude oil futures is immediately offset by the long 90.00 July crude oil futures contract, allowing Gary to show a futures gain of $9,000 (9 * 1000).
• Gary’s realized profit is the gain in the spread offsetting by the cost of the spread, or $6,210.

Conclusion

As you can see, there are opportunities in the options market using the bear put scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.