For many traders, options spreads are ideal ways of securing affordable market exposure while minimizing downside risk. In this article, we’ll cover the essential ins and outs of using a bear put spread.
What Is a Bear Put Spread?
A bear put spread is a multifaceted options trading strategy designed to profit from declining asset prices. When executing this strategy, a trader buys put options while simultaneously selling puts with a lower strike price on the same contract. This approach provides a way to secure bearish market exposure by buying and selling options contracts based on a common asset with identical expiration dates.
To illustrate how the strategy functions, assume that Ron the energy trader believes that persisting COVID-19 fears will hurt global oil demand in the coming months. It is April, and Ron estimates that the peak demand summer season will drive WTI crude futures to a yearly high of around $65.00 per barrel. With the price of December WTI trading at $59.25, Ron decides to execute the following bear put spread:
- Ron buys December WTI puts at an at-the-money (ATM) strike of $59.00. The paid premium is $6.68 per barrel, or $6,680 ($6.68 x 1000).
- Ron simultaneously sells December WTI at an out-of-the-money (OTM) strike of $58.00. The received premium is $6.17 per barrel, or $6,170 ($6.17 x 1000).
- The net premium associated with executing this trade is $510 ($6,680 – $6,170).
When the orders are filled, a limited liability bearish position is opened in the December WTI crude oil market.
Form and Functionality
So what has Ron accomplished by executing this strategy? First and foremost, he has reduced the trade’s initial capital outlay to $510. This is vastly less than the $6,680 needed to buy the December WTI put with strike at $59.00. Secondly, downside liabilities are limited by the spread’s structure. For all intents and purposes, the bear put spread’s outcome will adhere to one of the following scenarios:
The maximum profit for this strategy is the difference between the options’ strike prices and the premium. Assume that Ron’s trade goes according to plan and December WTI expires at $57.00. The net gain is the price discrepancy between the $59.00 and $58.00 strikes (100 ticks) minus the spread’s premium ($510). In this case, when December WTI expires at $57.00, Ron realizes a $490 profit: [($59.00 – $58.00) ÷ 0.01 tick] × $10.00 per tick) – $51o.
If December WTI comes off the board somewhere between $59.00 and $58.00, profits are realized from buying the puts @ $59.00. The written puts from $58.00 expire worthless. Assuming December WTI expires at $58.25, the trade’s bottom line is $240.00: [($59.00 – $58.25) × 10.00 per tick] – $510. In the event that the underlying asset closes between the strike prices of the bear put spread, profit or loss will depend on the premium paid and the actual closing price.
Should December WTI options expire trading above $59.00, Ron’s liability is limited to the premium paid (-$510). Essentially, the long and short put options work to create a net-zero outcome for the trader.
The bear put spread offers traders a way of assuming a short position in the market at a reduced up-front cost. The strategy also offers a reduced risk profile, which is an attractive feature for retail traders seeking methods with limited market exposure. However, it is up to the trader to balance the cost of buying ATM contracts with the revenue generated by selling OTM contracts. If a trader does not position the OTM and ATM strikes properly, it is possible to read a bearish market correctly and still lose money.
Getting Up to Speed with Options
To learn more about how to profit in the options markets, check out Daniels Trading’s Futures & Options Strategy Guide. Featuring 21 unique trading strategies, it is an invaluable resource for today’s active hedger or speculator.