What is Bear Put Spread?

Rishi is an amateur investor, while his friend Ishita has been active in the securities market for a long time. This is what happened during their friendly chat:

Rishi: The market has become bearish and wiped out almost all of my profits. I have no immediate liquidity when I need some profits.

Ishita: This happens when you only invest in stocks. As the market is volatile, you never know when the prices can fall.

Rishi: In a time like this, what do you do? How do you keep your portfolio healthy and realize profits? What do experienced investors do?

Ishita: Most of them look towards derivative trading, which includes buying or selling futures or options contracts.

Rishi: Derivatives trading?

Ishita: Yes, within derivatives trading, most investors prefer options trading as it does not force them to buy/sell the contract if they do not want to. Such contracts give them the right but not the obligation to sell the contract, allowing them to cut the risk of losses significantly. Another way to trade in options is through a strategy called Bear Put Spread which I am using right now.

But before you dive into how you can make profits through a bear put spread strategy, you must understand a little about options trading and related terms.

What is Options Trading?

An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract.

Types of Options Contract

Call Options

A call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties.

Put Options

A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the price on the date agreed upon by the contracting parties.

What is Bear Put Spread?

The bear put spread strategy or bear put spread is when an investor sells a put option while simultaneously buying another put option with the same underlying asset and the expiration date.

Unlike a bear call spread where the investor makes profits through the premium amount, a bear put spread demands the investor pay a higher premium and receive a lesser amount. Hence, there is a net debit in premium. However, it is not the premium amount from which an investor makes a profit in a bear put spread. The investors make profits through the difference in the strike prices of the two put options minus the net premium.

Investors use the bear put spread strategy when they believe that the market is bearish and the price of the underlying asset will go down moderately in a short period. The bear put spread strategy is also known as a bear put debit spread.

Bear Put Spread Example

It is almost the same as a bear call spread example. However, unlike a bear call spread, here there will be a net debit in the premium amount, and the maximum profit is the difference between the two strike prices of put options.

Here is an extended example to understand bear put spread:

Consider a company called XYZ, whose stock is trading at Rs 58. If you think that the price of the stock of XYZ will go down in a few days, you can initiate a bear put spread on the company. The following is the information about its options contract and the premium:

1. July 60 Put - Rs 3
2. July 55 Put - Rs 1

The Lot size is 100 shares.

An investor initiating a bear call spread can do the following transaction:

• Buy July 60 Put: 100x3 = Rs 300 paid as premium.
• Sell July 55 Put: 100x1 = Rs 100 received as premium.

Net Loss: Rs -200 (100-300)

Now, the three possible scenarios can arise in the bear call strategy:

Scenario 1: The stock price remains unchanged at Rs 58

• Buy July 60 put: Expires in the money with a value of (60-58)x100 = Rs 200
• Sell July 55 Put: Expires worthless
• Net debt paid as the premium was Rs -200
• Total profit/Loss = Rs 0 (200-200)

Scenario 2: Stock price goes up to Rs 62

• Buy July 60 Put: Expires worthless
• Sell July 55 Put: Expires worthless
• Net debt paid as the premium was Rs -200.
• Total Loss = Rs 200 (net premium paid)

Scenario 3: The stock price falls to Rs 54

• Buy July 60 Put: Expires in the money with a value of Rs (60-54)x100 = Rs 600
• Sell July 55 Put : Expires in-the-money with a value of Rs (54-55)x100 = Rs -100
• Total Profit: Rs 300 (600-100-200)

The 300 is the total profit earned due to the difference in the strike price minus the premium paid.

Advantages and Disadvantages of Bear Put Spread

Here are the advantages and disadvantages of a bear put spread:

Advantages

• There is always less risk exposure in bear put spread when compared to other strategies.
• Bear put spread offsets the cost of buying the put option with a higher strike price.
• As the risk is limited to the net cost of the bear put, the risk of losses is far shorter.
• Bear put spreads help traders manage volatility in the market and not lose money if the prices are going down.

Disadvantages

• In a bear put spread, investors can lose a huge amount of money if the price goes up drastically.
• A bear put spread is complex and can only be understood by knowledgeable and experienced traders.
• It limits profits to the difference in the strike price, which can be very less.
• If the market becomes bullish, there will always be a loss as the net premium is always in debt.

Similar to a bear call spread, a bear put spread also allows investors to bet against the falling market and make a profit. If you are well-versed with the bear put spread strategy, it can prove to be an effective technique to multiply wealth and mitigate the chances of losses. If you are interested in options trading, you can visit the IIFL’s website to open a free Demat and trading account. You can also download IIFL’s Markets app from the app store to open the accounts.

Now that you know what is bear put spread and bear put spread definition, you can go ahead and utilize the effective strategy.Checkout the PCR ratio to know the number of put options and call options traded in a day.