What is Bear Put Spread Strategy?

Bear put spread is a derivatives strategy that is usually implemented when the market outlook is slightly bearish and expectations of moderate fall are there and involves buying a nearby strike put option or an in-the-money (ITM) put option and selling a far-off strike put option or an out-of-money (OTM) put option.

Bear put spread strategy provides good gains if the underlying moves as expected by the trader or investor at the inception; however, if in case the underlying moves contrary to the expectations of the trader or investor, the loss is limited to the net premium paid (difference of the premium paid on buying the nearby strike put option and premium received on selling the far-off strike put option).

Formula

Where,

  • X1= Far off strike price of put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more soldX2= Nearby strike price of put option purchasedST= Closing price of underlying stock/index on expiryP1= Premium received on selling the far off strike put optionP2= Premium paid on buying the nearby strike put option

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Bear Put Spread Example

Let’s understand the concept in more detail by taking a real-life example.

Klain International has a moderately BearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more outlook on European markets and decided to enter into a bear put spread on the NIFTY INDEX to benefit from the outlook on 01.11.2019.

  • The current nifty index spot level as of 01.11.2019 is 12000.The current price of nifty 12000PE expiring on 27.11.2019 (monthly expiry) is $140The current price of nifty 11800PE expiring on 27.11.2019 (monthly expiry) is $70The lot size is 100 units.

This is entered by:

  • Buying one lot of nifty 12000PE for $140 (Total Cost= $140100=$14000)Selling one lot of nifty 11800PE for $70 (Total Cost= $70100=$7000)Net premium paid= $14000-$7000=$7000

The maximum profit under this spread is equivalent to $13000 (100*$130). Under this maximum loss to Klain International is limited to the net premium paid, i.e., $7000. The Break-even point under the bear put spread is 11930 nifty index spot level.

It reaches maximum profit when the underlying security reaches the far-off strike price put option, which in our case was 11800. And below this level, the profit will not maximize. Similarly, profit will increase between the two strike prices, i.e., 12000 and 11800, and the maximum loss will be equivalent to the net premium paid.

Advantages

  • It is a low-cost, limited-risk options strategy that benefits when the Market outlook is moderately bearish.The strategy benefits even in small price falls and doesn’t require a big fall to generate returns.

Disadvantages

  • It only results in a small profit as the upside is capped due to selling an out-of-money put option.If the underlying asset rises, it results in a loss of the entire net premium.The spread strategy works only when the outlook is bearish.

Difference Between Bear Put Spread vs. Bear Call Spread

Important Points

  • Both the option purchased and sold should be of the same expiry.Although the net premium amount paid is the maximum loss incurred in case the outlook fails; however, selling an option requires the keeping of a lot of margins, and the cost of funds of such margin needs to be accounted into while opting for such a strategy.

Conclusion

Professional traders frequently use the Bear put strategy in a moderately bearish outlook to generate moderate gains. The strategy is a low-cost, effective tool used even for hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more purposes. It is up to the trader/investor to determine the right strike pricesStrike PricesExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more and consider the implied volatility of the underlying to make better choices.

This has been a guide to What is Bear Put Spread Strategy & its Definition. Here we discuss the formula to calculate bear put spread examples, its differences with bear call spread, and its advantages and disadvantages. You can learn more about it from the following articles –

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