Bear Put Spread Strategy: If you’re thinking about investing in options, you should know that it can be a profitable but challenging experience. However, there are ways to increase your chances of success. One such method is the Bear Put Spread strategy. In this article, we’ll explore the details of this strategy and its components.
What is a Bear Put Spread Strategy?
A bear put spread is a two-legged options strategy that is used when the expectations from a security are moderately bearish in nature. It is a net debit strategy that starts earning profits as the price of the underlying asset decreases.
This strategy utilizes two put option contracts consisting of a long put(buy) at a lower strike price and a short put consisting of an even lower strike price. Here, the put contracts that are bought and sold should be of the same security and should be of the same expiry.
Components of Bear Put Spread Strategy?
The bear spread consists of two components:
- Buy a put option contract: This can be an ATM or OTM contract
- Sell a put option contract: This should be an OTM contract that has a lower strike price than the put contract bought
Let’s now explore this strategy in more detail using the Nifty 50 as an example. Considering the current spot price of the nifty 50 as 19400 here are the 2 legs to buy to set up a bear put spread strategy:
- Buy a put option contract at a strike price of 19350
- Sell a put option contract at a strike price of 19250
There is no restriction on the number of put contracts that are bought and sold. However, it must be done in proportionate quantities. For instance, if you purchase two lots of put option contracts, you should similarly sell two put option contracts at a lower strike price.
Thus, one can benefit from the downside through the put option bought and simultaneously reduce the total premium paid through the put option sold. It should also be noted that the level at which you choose to sell the put option contract should be based on where you predict the market will not reach.
Bear Put Spread Strategy
Max profit with Bear Put spread strategy
The maximum profit in this strategy is limited due to the put option contract being sold at a lower strike price. It can be calculated by subtracting the net premium paid from the difference between strike prices bought and sold.
Let’s use the Nifty 50 index as an example to make this simpler to understand.
Example: Suppose the Nifty 50 is trading at 19400. You buy one put option at the strike price of 19350 and sell one put option at the strike price of 19250. If the premium that is paid and received is Rs.95 and Rs.50 respectively. The following will be the maximum profit in this strategy:
Maximum Profit = (Strike price of PE Bought- Strike price of PE sold) – Net premium paid
Maximum Profit = (19350 – 19250) – (95 – 50)
Maximum Profit = (100) – (45)
Maximum Profit = Rs.55
In this example, the maximum profit a trader can earn from this strategy is Rs.55 from a single unit of a lot. Therefore, the profit earned from the entire lot will be Rs.55*50 units (Nifty lot size) which is equal to Rs. 2750.
Max loss with Bear Put spread strategy
The maximum loss is limited to the net premium paid while executing this strategy. Considering the figures from the examples mentioned above, the following will be the maximum loss in this strategy.
Maximum Loss = Premium Paid – Premium Received
Maximum Loss = 95 – 50
Maximum = Rs.45
Therefore, the profit earned from the entire lot will be Rs.45*50 units (Nifty lot size) which is equal to Rs. 2250. If one were to only purchase a put option contract at the strike price of 19550, then the total loss would be Rs.95*50 units = Rs.4750
Break-even point of Bear Put spread strategy
The break-even point represents the point at which one does not make a profit or loss. The break-even point for the bear put spread can be calculated by subtracting the net premium paid to the put option that is purchased.
Suppose you purchase a put option at the strike price of 19350 and sell a put option at the strike price of 19250 by paying a net premium of Rs.45. Then your break-even point would be:
Break-even point = Long put strike price – Net premium paid
Break-even point = 19350 – 45
Break-even point = 19305
This means you would start earning profits when the nifty will move below the level of 19305.
Benefits
The following are the benefits of a bear put spread strategy:
Reduced Costs: A bear put spread is cheaper than buying a naked put option as you receive a certain amount of premium from the put option sold.
Limited Losses: Since the maximum loss for the buyer of the options contract is limited to the net premium paid, executing a bear put spread strategy will also reduce your potential maximum loss.
Flexible Strike Prices: There is no fixed range in which one has to buy and sell the put options contract in order to execute a bear put spread strategy. The strike prices for this strategy can be adjusted as per the market outlook and personal preferences of the trader.
Drawbacks
Capped Gains: Although the bear put spread strategy reduces the total cost and losses, it also limits one potential gain. As we sell a put options contract at a lower strike price in this strategy, we forfeit the gains below the strike of the sold put option.
In Closing
As we conclude our article on the topic of ‘Bear Put Spread Strategy’, it is worth noting that this is a versatile tool. It enables option traders to profit from price increases while keeping their risk under control. This strategy is appealing because it strikes a balance between gains and risk management, despite the fact that the profit potential is limited.
Written By Aaron Vas
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