Bear Put Spread Explained (Simple Guide)
How would you like to earn a healthy return from a stock that you think will drop moderately in the near future? You can do that without even shorting the stock if you trade a bear put spread.
A bear put spread is similar to a long put except that it costs less. That’s because you’re selling another put option to help pay for the long put option.
Although it’s a cheaper alternative to a long put, you’ll pay in terms of opportunity. Your profit is limited.
In this guide, we’ll explain the bear put spread so you can determine if it’s right for you.
What Is a Bear Put Spread?
A bear put spread is a two-legged option strategy.
First, you buy one in-the-money put option. Then, you sell another out-of-the-money put option at a lower strike price.
On both sides of the trade, the options will have the same expiration date and the same underlying stock.
The result of the trade is a net debit to your account. That means it will cost you money.
It won’t cost as much as if you had just purchased the in-the-money put option, though. That’s because you get some money back when you sell the out-of-the-money option.
The following video provides details of how to execute a bear put spread option strategy:
When Would You Use a Bear Put Spread?
Use a bear put spread when you think the underlying stock will drop in price but not drop too much.
Why? Because you limit your profit with a bear put spread. If the stock tanks, you’d be better off if you had just bought a put option.
If you’re completely wrong and the stock rises instead of falls, you’ll lose money on the trade. The amount you lose will be equal to the total investment.
In that case, though, the amount you lose will be less than the amount you would have lost if you had just bought a put option.
How Does a Bear Put Spread Work?
For starters, make sure that your trading platform supports multi-leg orders. As I noted above, you’ll need to place two orders simultaneously with a bear put spread. Finding the right broker is important.
Read This Story: Top 6 Best Brokers for Options Trading (2019 Review)
Next, identify a stock that you think will drop modestly in the near future. Then, take a look at its options chains.
Specifically, look at the put options. Find one that’s in the money.
An in-the-money put option is one in which the price of the underlying stock is less than the strike price of the option.
Once you’ve found a suitable put option for the long trade, find one for the short trade next.
To do that, look for a put option with a strike price equal to your target price for the stock. That’s the option that you’ll sell.
That option, by the way, should be out of the money. That means the stock price is higher than the strike price.
After you’ve identified the options for both ends of the trade, go ahead and place the multi-leg order. Then, monitor the results to see if your trade turns profitable.
Real Life Example Using a Bear Put Spread
Let’s say chipmaker Micron Technology (NSDQ: MU) is currently trading for $35.50. You think it’s overbought and will drop in the near future, so you’d like to make money on the short side. You decide to go with a bear put spread.
You check next month’s options chains. You see that the $36 put option is currently offered at $2.07. That’s your in-the-money long option.
Your target price for the stock is $33.50. You check out the put option with that strike price and see that it’s bid at $1.10. That’s is your out-of-the-money short option.
You place the trade by purchasing a single $36 put option contract for $2.07. Remember, though, options contracts are offered in batches of 100 shares each, so that will cost you $207 ($2.07 x 100 = $207).
Next, you sell the $33.50 put option for $1.10. That earns you $110 ($1.10 x 100 = $110).
So the total cost to you for the trade is $97 ($207 – $110).
Let’s say that your prediction was accurate and Micron Technology drops to $33.55 per share when the contract expires. What happens then?
You make money.
The $36 put option that you purchased will trade for about $2.45. You’ll sell it for a gain of $38 ($245 – $207 = $38).
The option that you sold for $110 will expire worthless because it’s just out of the money. So you keep the entire $110 you earned from selling that.
So your total profit for the whole trade is $148 ($110 + $38 = $148).
Congratulations! You placed a winning trade.
What Are Similar Strategies Related to Bear Put Spread?
Here are some strategies similar to a bear put spread:
- Bear Call Spread – Very similar to a bear put spread except it uses call options instead of put options.
- Bull Put Spread – A spread strategy that turns profitable when there’s a modest increase, instead of a modest decrease, in the underlying stock price.
- Long Put – The same thing as a bear put spread except that it doesn’t involve selling a put option. It’s a more expensive version of the bear put spread without the limited return.
Bear Put Spread Compared to Other Options Strategies?
Like many other options strategies, the bear put spread limits both your risk and your return. That’s because you hedge yourself by selling one option while buying another.
It’s also more affordable than a long put. The sale of the put option offsets the cost while still offering a healthy, even if limited, return.
Advantages & Risks of a Bear Put Spread
- Limited risk – Because there’s a short and long side to the spread, your risk is limited. In fact, your maximum risk is limited to the amount that you spend on the overall spread.
- Healthy returns – Although the return is limited because of the short side of the trade, you can still make a nice return. In the example above, you made a $148 profit on a $97 overall investment. That’s a good month of trading on a percentage basis!
- Limited return – You can’t “let your winners run” with a bear put spread. That’s because your profit is limited if the stock absolutely tanks.
- Time decay – Even if you were right about the direction of the stock, time decay might eat into the long put position to such an extent that the trade becomes unprofitable.