Bear put spread OPTION TRADING STRATEGY EXPLAINED
-With examples from stock option trading
Here I'll explain how to construct a bear put spread. The bear put spread option trading strategy is suitable when you expect a moderate fall in the underlying. The strategy has both limited profit and limited loss.
A bear put spread is constructed using two put options with different strike prices. The put option with the higher strike is bought and the one with the lower strike is sold. As put options are more valuable/expensive the higher strike they have, going long a bear put spread entails an initial investment. Shorting the same option trading strategy entails an initial revenue.
The larger the difference in strike prices between the two puts, the more expensive the bear put spread is going to be. Next: Payoff diagram for the bear put spread option trading strategy explained.
Example of the bear put option trading strategy:
Underlying stock: Company A
Stock price: 18$
Put 1: Strike = 15$, price 3$
Put 2: Strike = 10$, price 1$
Both put 1 and put 2 mature in 6 months.
Going long (buying) put 1 (spend 3$) and and going short (writing) put 2 (receive 1$) would cost us a total of 2$ (-3$ + 1$) per bear put spread. We'd get the following profit/loss profile:
Graph
This position has a maximum profit of 3$. This happens if the stock price is 10$ at expiry. In the case the long 15$ put is worth 5$ and the short 10$ is worthless. We thus exercises the long put and make 5$. Subtracting the 2$ the position cost to put on, we are left with a profit of 3$, a 150% return.
Let's say we expect the stock price of company A to fall. Two simple trading alternatives for this situation is obviously to short the stock or to buy a naked put. These two position are both bullish but have some disadvantages. By using a bear put spread we can to some extent get around the problems with shorting the stock or buying a naked put. The advantages and disadvantages of the bear put spread option trading strategy are:
1) Shorting stocks is easier said than done. Especially stocks with low trading volume. For a small trade it is usually easier to find liquidity in the options market than to get your broker to chase up a small post of stocks to borrow. Some brokers keep an inventory of stocks or deal with a market maker who does which makes it easier to short these stocks.
Next: More aspects of the bear put spread option trading strategy explained.
2) A bear put spread costs less than the naked put with the higher strike price. We can use this either to reduce our maximum loss or to increase our leverage. Using the the numbers from before:
Stock price: 18$
Put 1: Strike = 15$, price 3$
Put 2: Strike = 10$, price 1$
Investing 1,800$ is this trade gives us a maximum position of:
100 shares or 600 naked puts or 900 bear put spreads. Let's compare those 3 positions so we can see which trade suits which market situation. Our bear put spread reaches maximum profit of 3$ at a stock price of 10$. This gives us a total profit of 2700$ (3$*900 bear put spreads). Below a stock price of 10$ there is no change to the profit of this option trading strategy as the long and the short put cancel each other out. Had we instead bought 600 naked puts at 3$ each, a stock price of 10$ would have yielded a profit of 1200$ (Revenue = 5$*600 - Cost = 3$*600). Shorting 100 stocks when the stock price was 18$ and then buying them back at 10$ would have given us a 800$ profit. Next page discusses to pros and cons of these numbers.
Reiterating the maximum profits at a stock price of 10$:
Naked put: 1200$
Shorting the stock: 800$
Buying bear put spreads: 2700$
So as long as we're right about the market and the stock goes to 10$, the bear put spread option trading strategy is our best choice. But we need to consider what would happen if we're wrong.
First thing to note is that it costs us money to put on this option trading strategy. Going short the stock doesn't cost anything except the fees to the broker. So if the stock stands still untill our options expire we're stuck with a loss of 1800$. The loss would be the same for the naked put, but 0$ if we had shorted the stock. This is true for all net long option trading strategies held till expiration: they become worthless if the stock price stands still. Discussion continued on the next page.
Let's say we're right in expecting the stock price to fall. What happens if it falls below 10$? The profit of our bear put spread does not increase below 10$. But a naked put or a short stock keeps making money as the stock price falls. When the stock price reaches 7.5$ the profit of the bear put spread option trading strategy and a naked put is the same, 2700$.Below this the naked put profits 1$ for each $ off the stock price. So the profit on the 600 naked puts would be 3300$ at a stock price of 6.5$ and so on. Obviously short stocks also keep making a profit as the stock price drops. But with a total of 1800$ exposed to the short stock the maximum profit of this position would be 1800$. Never better than the bear put spread trading strategy even if the company goes bankrupt and the stock price goes to 0$. More of the pros and cons of the bear put spread option trading strategy explained on the next page.
We've established that shorting the stock is never better than risking the same amount of money in the bear put option trading strategy. We've also seen that spending the same amount on naked puts is better if the stock price was to fall a lot. To be more specific: if it goes below 7.5$. But what about a moderate decrease in price? In this case the bear put spread beats the naked put but not always the short stock.
After all, it cost us 2$ per piece to put on thes option trading strategy but nothing to short the stock. The 100 short stocks are profitable from the first cent the stock price drops. The 900 bear put spreads make us 1$ for each $ drop in the stock price but they have the total outlay of 1800$ to make up for. As it turn out, the profit of these two positions are exactly the same, 225$, when the stock price is 15.75$. So at all prices below 15.75$ the bear put spread beats the short stock if we had put the same amount of money into both positions. Were did 15.75$ come from? Explained on the next page.
We knew that for low stock prices the bear put spread option strategy beats the short stock. We also know that if the stock price stands still, the short stock beats the bear put spread. So somewhere in between no drop and a large drop they option trading strategy and the short stock yields the same profit. By simply writing and equation for the profit of each position and equating them we can solve for that stock price.The profit of the bear put spread strategy: We have 900 bear put spreads, so for each $ fall in the stock price we'd make 900$. We'd also spend 1800$ putting on the position. If we call the fall in the price of the stock P, we can write the profit of the bear put spread option trading strategy as (note that P is how much the price goes below 18$):
Profit bear put spread = 900*P-1800
A short position in 100$ makes 100$ for each $ the price goes down and doesn't cost anything to put on. So the profit of that position is (again P is how much the stock price goes below 18$):
Profit short stock = 100*P
So exactly for which prices is the bear put spread more profitable and for which is shorting the stock more profitable?
They yield the same profit at:
Profit short stock = Profit bear put spread
100*P = 900*P-1800
P = 2.25$
As we defined P as the price drop from 18$, the two positions yield the same profit at 15.75$ (18$ - 2.25$).