What is Bear Spread?

You can trade several ways when you feel a stock will go down.

  1. Shorting a Stock

  2. Buying a Put

  3. Entering into Bear Spread

The strategies mentioned in “a” and “b” are most effective when the stock price decreases drastically. There is no protection in the above two strategies. If the stock price goes up, there will be unlimited loss in strategy “a” and limited loss in strategy “b.” They help to minimize the initial cost of Strategy “b.” It helps to reach the breakeven point faster.

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Example of Bear Spread

Say the stock price in the market is 100, and the put premium at different 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 are mentioned below:

Put @98 – Premium is 5

Put @95 – Premium is 3

  • So if you had followed strategy “b” (Buying a Put), you would have just bought the put at strike 98. So if the stock price had reached below 93 (98 Strike less the premium paid, this is the Breakeven point), you would have started making a profit.Here you don’t think that stock price will go so low, so you are bearish, but moderately. So what will you do to minimize the premium you need to pay for the 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? You can sell a put option below the 98 strike price. The put option that is available below the 98 strikes is 95 strikes. You feel that the stock price will not go below 95. You can trade the profit potential below 95.So you can sell the put at the strike of 95. You will earn a premium of 3 now. Your net investmentNet InvestmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth.read more now will be 5-3=2. So you entered the strategy with an initial investment of 2. The break-even point changed from 93 to 96 (98-2). That is a huge improvement as you were unsure whether the stock price would reach the previous breakeven point, 93.

So now, if the stock price stays above 100 or 98, it will be your second loss of 2. What will happen if the stock price goes below 98.

Stage 1: Stock Price above 98. You will incur a loss of 2. Because both the put options will expire. 2 was your initial investment

Stage 2: Stock price from 98 to 96. As soon as the stock price crosses 98, the put you bought will be activated. So when the stock price reaches 96, the gain from put will be 2. Your initial investment was -2, so you will reach Breakeven. This means there will be no profit or no loss at this stage.

Stage 3: Stock Price between 96 to 95. This is the stage where you will earn a profit. As you have recovered the investment, you will earn a profit of +1 here.Stage 4: Stock Price below 95. At this stage, the put that you have sold will be activated. So you will not be able to earn any more profit from this stage. So your Net profit will remain at 1.

Stage 4: Stock Price below 95. At this stage, the put that you have sold will be activated. So you will not be able to earn any more profit from this stage. So your Net profit will remain at 1.

Types of Bear Spread Strategies

There are two types of bear spread strategies.

Bear Put Strategy has already been explained above, so that we will explain the Bear Call strategy here.

#1 – Bear Call Strategy

You may wonder why they have used calls when the strategy is bearish. So this strategy is to prove that you can also use call options when you feel the market will go down.

The most lucrative strategy to be used in case you feel that stock price will go down is call writing, also known as the Selling Call option. Call Option writingCall Option WritingIn writing a call option, a person sells the call option to the holder (buyer) and is obliged to sell the shares at the strike price if the holder exercises it. In exchange, the seller receives a premium from the buyer.read more has the potential unlimited losses if the stock price goes up instead of going down. So to safeguard from the risk of unlimited losses, investors enter into a bear call strategy. They buy out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more call at the higher strike in case of the stock price rises.

#2 – Bear Put Strategy

If an investor is bearish about the market, he is not so bearish. He thinks the stock price will go down but will not decrease drastically. He should buy a put option and minimize the cost of the premium paid. He should sell another out-of-the-money put option. The premium earned from the out-of-the-money will help to lower the initial cost and help to reach the breakeven point fast.

Advantages

  • Markets are mostly moderate in movements, so this strategy is most useful. It is helpful when the market is 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. So in case of extreme movements, other strategies should be used.The bear strategy helps to reduce the cost of buying a put when a person is moderately bearish. The lower cost will help him to reach the breakeven point fast.Bear Strategy also helps an investor protect himself from unlimited losses. If an investor is selling a call option, there will be unlimited potential for loss. So Bear’s strategy helps an investor to limit losses.

Disadvantages

  • Shorting options requires huge margins, which is difficult for small investors to arrange.Getting the options at correct strike prices is also a big challenge as options at all possible strike prices are unavailable.There are transaction charges, brokerage charges, and several other charges which may prevent an investor from earning the optimum profit.Not all stocks are present in derivative marketsDerivative MarketsThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.read more. So if the stock doesn’t have options running in the derivative market, then it will not be possible to make these strategies.

Conclusion

Bear Spread Strategy is a price spread where you buy similar options like Call and Put at different strikes but with the same maturities. So these strategies are designed so that both profit and losses can be limited. The share marketShare MarketThe share market is a public exchange where one can buy and sell company shares based on the demand and supply of shares. read more has become extremely unpredictable. The market mostly runs on sentiments now. So one must protect himself in case he is taking any position. Bear spread strategies give protection.

This has been a guide to what Bear Spread is. Here we discuss two types (Bear Call and Bear Put), an example of bear spread, and advantages and disadvantages. You may also have a look at the following articles –

  • Options SpreadAmerican OptionsOption ContractWriting Put Options