Bear Put Spread

A Bear Put Spread is a bearish options strategy utilized when an investor is confident that the price of a stock will fairly decline. It entails purchasing a put option at a higher strike price and synchronously selling a put option at a lower strike price. The both options share the exact same expiration date. This strategy reduces both the potential profit and potential loss, making it a defined risk strategy.

Elements of a Bear Put

1. Buy Put Option (Long Put): This involves the investor buying a put options with a higher strike price, with the expectation of a drop in the stock price.

2.Sell Put Option (Short Put): This involves the investor selling put options with a lower strike price, which balances out part of the cost of the long put but limits the maximum profit.

Bear put spread options investing strategy

Profit and Loss

Max Profit: This happens when the stock price drops below the lower strike price by expiration.
Max Loss: The cost of entering the trade (the net premium paid), which occurs if the stock price stays above the higher strike price by expiration.
Breakeven Point: This is the stock price at which the strategy neither makes grows nor loses money. It is calculated by subtracting the net premium paid from the higher strike price.

An Illustration Using Apple Stock (AAPL)

We are going to assume Apple's stock is trading at $180, and you expect a fair drop in its stock price. You resolve to set up a Bear Put Spread:

Purchase a 180 strike put (Higher strike): It costs you $7 per share (a total of $700, as each option controls 100 shares).
Sell a 170 strike put (Lower Strike): You get $4 per share (a total of $400).

Important transactional notes:

Net Premium Paid = $700 (long put) - $400 (Short put)= $300.
Maximum loss = $300, which is the amount you paid for the spread (net premium).
Maximum Profit = (Difference in strike prices - Net Premium Paid) = ($180 - $170) - $300 = $700.

Possible Scenario Outcome:

1. A fall in Stock price Below $170: All things been equal, this is the best- case scenario. An investor can sell the stock at $180 with the use of long put, while the short put obligates you to buy it back at $170. This yields a maximum profit of $700 (excluding transaction fees).

2. Stock Price positioned between $170 and $180: The investor still makes some profit, but less than the maximum. For example, if Apple's stock ends at $175, the long put is worth $5 ($180 - $175), and the short put expires worthless. The investor's profit would be $500 subtracted by the $300 net premium, which gives him $200 profit.

3. Stock Price maintains position above $180: The long and short puts expire worthless, and the investor loses $300 premium paid, and that is his maximum loss.

Why Use a Bear Put Spread?

1. Minimum Risk : There is an awareness of the highest amount the investor can lose upfront (the premium paid).

2. Cost Efficiency: The short put reduces the cost of buying the long put.

3. Limited Reward: While your upside is capped, the investor is positioned for a moderate decline in the stock price.

Conclusion

A Bear Put Spread is a bearish strategy for traders expecting a fair decline in stock's price. Just as illustrated with the Apple stock, the strategy lets you take profit from a decline while limiting risk, hence making it a common choice for defined-risk trades.