Bear put options spreads are a less costly way of making a wager that stocks will fall than buying put options alone.
When you expect that a share price will fall lower but lack full conviction in your view, a bear put options spread is a way to make money from a share price decline but limits risk compared to purchasing long puts.
If a stock does fall by a large amount, long puts alone would make more money than bear puts.
Bear puts are a lower risk way of betting against the market, but also a lower reward way of making money on share price declines.
If you believe a share price will drop but not by a huge amount, a bear put spread is a good options strategy to employ. But if you thought a stock market crash loomed up ahead, long puts by themselves would offer higher profit potential.
So how do you trade a bear put options spread?
How To Make Money
When Stocks Fall: Bear Put Spread
Bear puts are vertical options spreads because higher strike put options are bought at the same time as lower strike short put options are sold.
The puts you buy will cost you more than the puts you sell will pay you, so bear puts are known as debit spreads.
Options spreads that cost you money to place a wager are called debit spreads while options spreads that put money into your pocket are called credit spreads.
Like almost all debit spreads, bear puts require share price movement to profit. That might seem obvious but when you place a credit spread, you can sometimes make money even when a stock doesn’t move in price whatsoever.
In the case of a bear put spread, you need an underlying stock to fall in order to make money.
Generally, it is wise to choose an expiration month for a bear put spread that is far enough into the future that the stock has enough time to make its move lower.
>> Caution: Debit spreads suffer from time-decay, which accelerates closer to expiration, so you want to place put options sufficiently far out in time to avoid the negative effects of this options Greek.
>> Related: How To Trade An Options Straddle
Bear Put Spread Basics
Bear put spreads are created when you:
- Buy a higher strike price put option
- Sell a lower strike price put option
When you fork over capital to buy a put(s), your bet is that the underlying stock will decline in price.
And when you sell puts to begin a trade, you receive money into your brokerage account. These puts are called short puts, and are bullish bets that the market will rise.
It seems counterintuitive then to both buy puts and sell puts to kick off a new trade. Don’t they cancel each other out?
As it turns out, options prices are influenced by various factors. One of those is called delta, and when you place a bear put spread, the long put will make more money when the underlying stock falls than the short put will cost you.
WHAT IS AN OPTION DELTA?
Take the example where you buy a put with a delta of -0.50. When the stock falls $1, you make $0.50.
When the stock declines in price by $1, the short put loses money and if its delta is 0.20 then it loses just $0.20.
The delta for the bear put spread is -0.30 overall (-0.50 + 0.20), so a decline in share price by $1 will lead to a $0.30 gain in the bear put spread. And vice versa, a $1 rise in share price will lead to a $0.30 loss in the bear put spread.
If you paid a couple of dollars to buy a bear put spread, and the stock fell just $1, the % return you earn is 15%.
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How To Buy A Bear Put Spread
When you buy a bear put spread in your brokerage or retirement account, such as an IRA, 401(k), or Roth IRA, you would execute the following orders.
|Option Type||Action||Strike Price||Expiration|
|Long Put||Buy To Open||Higher||Same month|
|Short Put||Sell To Open||Lower||Same month|
Leading options trading platforms, such as thinkorswim and TastyWorks, cater to advanced options order entries, including bear put spreads as well as more complex spreads, such as iron condors, and ratio backspreads.
When you place a debit spread, such as a bear put spread, you will almost always want to exit it before expiration.
A nice feature of the TastyWorks platform is that no commissions costs are charged when closing contracts.
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HOW TO OPEN AND CLOSE A BEAR PUT OPTIONS SPREAD
To place a bear put spread, enter a Buy To Open order for the number of long put contracts you wish to buy and simultaneously a Sell To Open order for the equivalent number of short put contracts you plan to sell.
Closing out a bear put spread means placing a Sell To Close order for the long puts and a Buy To Close order for the short put contracts. Both orders can be placed at the same time on most options trading platforms.
>> Caution: If you enter more short put contracts than long put contracts, the additional short puts will be treated as naked puts by your broker, and subject to larger margin requirements.
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Bear Put Spread Risk Graph Example
XYZ stock is trading at $70 per share.
You buy a long put at a strike price of $70 and sell a short put at strike $60.
When you buy the long put, you will pay the Ask price for it.
And when you sell the short put, you will receive its Bid price.
Long Put Ask Price = $5
Short Put Bid Price = $2
Bear Put Spread Cost = $5 – $2 = $3
No matter how high the stock rises, the risk is never greater than $3 per share or $300 per contract.
BEAR PUT RISK GRAPH
|Stock Price||Long Put Profit|
|Short Put Profit|
|Bear Put Profit|
When the stock falls from $70 by the amount you paid for the bear put spread, $3, to $67, the bear put reaches its theoretical breakeven level, which is the share price at which no money is lost at expiration excluding commissions costs and fees.
The breakeven level is $70 – $3 = $67
Note: If the stock fails to decline to $67 by expiration, the bear put will show a loss.
It is also noteworthy that the most you can lose and the most you can make are both fixed to a certain amount.
You can make no more than $7 per share, or $700 per contract, and you can lose no more than $3 per share, or $300 per contract.
Even if the stock soars from $70 to $500, the bear put can still lose no more than it cost to enter the trade – unlike a short stock position, which has theoretically unlimited risk when share prices rise.
The maximum profit potential in a bear put spread is calculated as follows:
Maximum Profit Potential = [Long Put Strike Price – Short Put Strike Price] – Bear Put Cost
Maximum Reward = [$70 – $60] – $3 = $7
So, the most you can make is $7 per share or $700 if one contract of each put option is traded.
Bear Put Options Spread Tips
TIME DECAY IS YOUR ENEMY
If you buy a bear put spread very far out in time, you may end up fighting the general trend of the market, which over long time periods is up.
But placing a bear put spread over a very short time period is not the answer either because the options greek, time-decay, can hurt the debit spread.
So, a general rule of thumb is to buy a bear spread with at least 30-45 days of time value but probably not much more than 60-90 days remaining to options expiration.
Of course, there will be exceptions to the rule depending on your outlook so none of these guidelines are set in stone.
KEEP BID-ASK SPREAD LOW
When you buy stocks, you pay an Ask price and when you sell stocks you receive a Bid price. Similarly with options, this bid-ask differential called slippage can hurt your profitability, especially if it is large.
Stocks that are traded actively and liquid often have narrow bid-ask spreads while those with low trading volumes tend to have larger spreads.
When it comes to options, a large amount of open interest and volume generally translates to narrows bid-ask spreads too.
So target stocks that are more heavily traded when placing bear put spreads, and you will lower the chances of wide bid-ask spreads taking a big chunk out of your profit margins.
USE IDENTICAL CONTRACT NUMBERS
Vertical spreads, such as bear puts and bull calls, should be placed with the same number of long and short options contracts.
Good options trading brokers will allow you to place the same number of contracts simultaneously so you don’t have to leg into the options spread – a process whereby one side of the spread is entered at a different time to the other side, for example buying long puts and subsequently selling short puts.
If more short options were entered than long options, the additional short puts would be treated as naked puts by your options broker, and would require you to have more capital in your account because it’s a higher risk position.
>> Related: Options Trading For Dummies
EXPIRATION MONTHS SHOULD BE IDENTICAL
When both options are placed in the same expiration month, the bear put spread is labeled a vertical spread.
If you bought the higher strike price long puts further out in time than where you sold the lower strike price short puts, you would end up with a diagonal options spread.
>> Note: When both options are the same strike but in different expiration months, the spread is called a horizontal calendar spread.
DANGER, DANGER – HIGH VOLATILITY
High levels of implied volatility in options debit spreads can sometimes narrow the delta differential.
This means that when a stock declines in price as you expect, the amount you make on the spread may be lower than you might intuitively expect.
For example, if the stock fell $1 and the delta of the spread was -0.20 then you would make just $0.20 for the first dollar the stock fell.
If the bid-ask spread of the options were $0.05 each then slippage would cost you $0.10 total or 50% of your profit on that first dollar of downward movement!
So, double check what the delta of the bear put spread is before placing the trade so you are not caught by surprise making less than you expect when the share price of the underlying stock declines.
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When Should You Trade
A Bear Put Spread?
Bear puts are applied when you have a moderately bearish outlook.
If you expect a stock to really plummet lower, a long put would serve you better by making more money.
But when a pullback in share price is expected yet you are not fully certain it will materialize, the bear put offers a lower risk way of making a bearish wager than a long put.
Which Stocks Work
Best For Bear Puts?
MODERATELY BEARISH TREND
Bear put spreads work well on bearish trending stocks that are steadily declining or pulling back to technical support levels.
Stocks that are rising or moving sideways are usually poor candidates for a bear put spread because the bearish trend needed is not in effect and time-decay will eat away at the debit spread position.
LIQUID STOCKS & OPTIONS
Low-priced stocks and penny stocks that don’t have options or have options with wide bid-ask spreads should generally be avoided when it comes to placing bear put spreads.
BE WARY OF STOCKS DUE TO REPORT EARNINGS
Some news events can predictably lead to volatility in share prices. For most companies, though not all, earnings seasons take place in January, April, July, and October. When you know earnings season is approaching, the risk of trend changes is high.
If you plan to place a bear put spread, pay close attention to earnings and other news events that may disrupt a bearish trend that would lead to a bear put profiting.
Have you traded bear put options spreads? How did they work out for you? We would love to hear from you in the comments below.
>> READ: Don’t Put All Your Eggs In One Basket
>> Find Out How To Research Stocks
>> Get To Know Options Trading Basics
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