Chapter 5

Long Bear Put Spread Option Strategy

Getting into a college of your choice, with the subject you want is tough, unless you are part of the ‘98%-plus club’. Thus, most students strategise like options traders - going long or short on their colleges of choice- and hope for the best.

Say St. Xavier’s, Mumbai is your dream college and you wish to study Economics here (for the uninitiated, St. Xaviers is a top tier college in India and it is known for English Literature, not Economics). Typically, the college posts a higher cut-off for the Arts stream versus the other streams. The college also offers a Commerce program with Economics. You want to try your luck for both. Listed below are the cut-off marks.

Meanwhile, you have scored 90%.

You get accepted to the Commerce course and you take admission. A month later, you see that the third merit list for Arts has dropped to a significantly lower cut-off - 89%. You are a shoo-in. Since you have already paid for the Commerce seat, you also don’t forfeit the fees. The college transfers you to the Arts department and refunds the balance amount. 

You get the college of your choice, the subject of your choice and you save the fees you would have to forfeit (had you taken admission in another college) and you get a refund. A Bear Put Spread Strategy is somewhat similar. 

Why would you use this? 

A trader will enter into a Bear Put Spread Strategy if they believe two things: 

1. The underlying stock or index will move downward but not drastically downward. 
2. You expect this downward move to occur prior to the selected expiration date of the option.

How do you construct it? 

A Bear Put Spread consists of purchasing a put option at one strike price and selling another put option at a lower strike price. Both of the bought and sold put options will have the same expiration date. 

When you sell a put option, you will receive the premium associated with the option unlike the premium that you pay when you buy a put option. Due to this combination of buying and selling of a put option, the net cost of entering this strategy will be cheaper than simply entering into a long put trade.

The table below is an example of an option chain with bid and offer prices for 5 strikes associated with calls and puts of the same expiry. 

The current price of the underlying is 395 so the 395-strike is the ‘at-the-money’ strike price. If you were ready to place a trade for a long bear put spread strategy, you would look to the right side of the option chain for the put option section. 

Let’s look at two quick examples: perhaps you decide to enter into a 390-395 spread or a 385-395 spread. The 390-395 spread involves buying the 395-strike put option and selling the 390-strike put option. The cost to buy the 395-strike is 6.37. When you sell the 390-strike, you will receive the amount of the bid price which is 4.42. The net cost to enter the 390-395 bear put spread is 1.95 (4.42 – 6.37). 

For the 385-395 spread, it will cost 6.37 to buy the 395-strike and you will receive 3.03 in premium by selling the 385-strike. The net cost to enter the 385-390 bear put spread is 3.34 (3.03 – 6.37).

Illustration 1

What is the maximum gain and profit? 

The maximum payoff from a Bear Put Spread is the difference between the two strikes. The maximum profit from this strategy is the difference between the two strikes minus the net cost to enter the trade. In the two examples above, there were two spreads 390-395 and 385-395. 

For the 390-395 Bear Put Spread, 

• The maximum payoff is 5 or 390-395. 
• The maximum profit is 3.05 which is 5 minus 1.95 (the spread minus the net cost to enter the position). 

With the 385-395 Bear Put Spread, 

• The maximum payoff is 10 as that is the difference between 385 and 395. 
• The net cost for this trade was 3.34 so the maximum profit is 6.66 (the spread of 10 minus the net cost).

Key Formulae

• Long Bear Put Spread Payoff = Higher Strike Price – Lower Strike Price
• Long Bear Put Spread Profit = Higher Strike – Net Cost of Strategy

What is the maximum loss? 

The maximum loss is capped at the price you paid to enter the strategy. In the 390-395 spread example above, your max loss is 1.95. By comparison, your max profit is 3.05.

What is the break-even point? 

The break-even point is the upper strike price minus the net cost to buy the spread. This is the opposite of the bull call spread which has a break-even point of the lower strike price plus the net cost to buy the spread.

In the 390-395 spread example, the net cost to enter the trade is 1.95. The break-even point for this trade is 393.05 = the upper strike of 395 -minus 1.95 (cost of trade).

Key Formulae

• Break-even Point = Higher Strike – Net Cost of Strategy

Since the underlying is trading at 395, the underlying needs to move down by 0.49% in order to be profitable. The maximum profit occurs when the underlying is at the lower strike of 390. For this trade to reach its maximum profit, the underlying would need to move down at least 1.27% as of the expiration date.

Illustration 2

Why would you trade a Bear Put Spread instead of just a long Put? 

Trading long puts is simpler to manage in terms of entry and exit when compared to bear put spreads. However, long put positions require larger downward movements in the underlying stock or index to reach profitability. 

The cost to enter a bear put spread strategy is lower as you simultaneously purchase and sell a put option. The lower strike sold is further out-of-the-money so the price is less than the higher strike price purchased thus creating a lower price point. 

Beginners typically avoid spread strategies due to their slightly higher complexity. This, however, puts new options traders at a disadvantage. 

Here is a quick example that shows why: 

Illustration 3

Look at the table above for a comparison of the two strategies. Here’s what you will find:

1. With the 390-395 spread, the net cost to enter the strategy is 1.95. By comparison, the cost to purchase a put option with only the 395-strike would be 6.37. 
2. In the above table, you can see a far smaller price change of -0.49% is needed to break-even with the Bear Put Spread vs. a price change of -1.61% for the Long Put. 
3. In addition, the maximum profit for the Bear Put Spread is achieved at an underlying price of 390. This needs a price change of -1.27%. Therefore, the Bear Put Spread will have reached maximum profit even before the Long Put breaks even. 
4. Meanwhile, the maximum profit amount for the Bear Put Spread is 3.05 when the underlying is at or below 390. In order for the Long Put to make a 3.05 profit, the underlying would need to go down by 2.38%. (To calculate this, you would subtract the 3.05 max profit for the Bear Put Spread from 388.63 which is the break-even price for the Long Put). 
5. Therefore, the put option needs the underlying to move +87% more (-2.38% vs. -1.27%) to reach the same dollar profit amount as the bear put spread. 

Bear Put Spread Scenarios using Historical Data

To conclude this chapter, we will walk through a few examples using real market data to understand the opportunities and risks of the bear put spread strategy.

Scenario 1 – Underlying is below the break-even price at expiration

The Situation:

• The trader is bearish on the Nifty which is trading at 17,807.65.
• The trader decides on a put spread with a 2-week expiration. The trader buys a put with the 17,800-strike price and sells a put with the 17,600-strike price.
• The 17,800-strike costs 222.35 and the premium received from selling the 17,600-strike is 150.35. The net cost of the bear put spread is 72.00.
• The break-even price for the put spread strategy is when the Nifty is at 17,728 (17,800 - 72).

What happens:

• The Nifty trends downward in the trader’s favour for the first week. After one week, the Nifty closed down 1.86% to a price of 17,475.65.

• At this point, the 17,800-strike put option purchased for 222.35 is now worth 337.20. Because the Nifty is at 17,475.65, the intrinsic value is 324.35 (17800 – 17475.65).
• The time value remaining on this option is 12.85 which is the current option price of 337.20 minus the intrinsic value of 324.35.
• On the other hand, the 17,600-strike put option you sold for 150.35 has moved against you and now costs 191.60 if you wanted to close it out.
• The current profit if you were to close out would be 73.60. This is a combination of the profit on the long put of 114.85 (337.20 – 222.35) and the loss of -41.25 (150.35 – 191.60) on the short put option.
• You believe that the Nifty will keep trending your way and would rather wait for the short call option to expire worthless to increase your profit to the max potential.
• Throughout the second week, the Nifty continues to trend downward. On option expiration, the Nifty closes at 17,392.60.

Trade Results:

• The put spread option is in-the-money and has an intrinsic value of 200. This is calculated as the difference in two strike prices of 17,600 and 17,800. The trade reached the maximum payout and profit due to the underlying closing below the lower strike price of 17,600.

• Let’s go a bit further in detail to understand the mechanics of the payoffs. The long put option will be worth 407.40 on expiration.
  • This is calculated by taking the difference between the long strike price of 17,800 and the underlying price of 17,392.60.
• The short put option will be worth -207.40 on expiration. If you had purchased the put option, the payoff would be the difference between the strike price of 17,600 and the underlying price of 17,392.60. This value would be 207.40.
  • However, since you sold this option rather than purchasing, your payoff is the inverse: -207.40.
• The sum of 407.40 and -207.40 is 200 which is also the difference between the two strike prices.
• As long as the underlying ends below both strike prices, the payoff will always be the difference between the two strike prices. For example, if the underlying was 1, 10, or 100 lower than what it actually closed at, it wouldn’t make a difference. This is because the long put would go up in value by 1, 10, or 100 but that would be offset by an equal loss in the short put of 1, 10, or 100.
• This trade is profitable with a net profit of 128. This is the payoff of 200 reduced by the cost to buy the put spread of 72.

Results compared to Long Put:

• If the trader instead only purchased a long put at the 17,800-strike, this would have cost them 222.35. The break-even price would have been 17,577.65.
• This trade would have also been profitable with a gain of 185.05. 
• The gain for the long call of 185.05 is higher than the gain of 72 of the bear put spread. 
• The gain-to-cost for the put spread is 1.78 which is the profit of 128 divided by the cost of 72.
• However, the gain-to-cost ratio for the long put is much lower at 0.83. This is due to the profit of 185.05 divided by the much higher cost of 222.35.

Scenario 2 – Underlying is below the upper strike but above the break-even price at expiration

The Situation: 

• The trader is bearish on the Nifty which is trading at 17,670.45.
• The trader selects to implement a bear put spread with options that have 1-week until expiration.
• The trader buys the 17,650-strike put option for 127.60 and receives 92.1 in premium for selling the 17,550-strike put option.
• The net put spread cost is 35.50 which is the difference between 127.60 and 92.10.
• The break-even is 17,614.50. This is calculated as the difference between the upper strike price of 17,650 and the net put spread cost of 35.50.
• The max profit for this trade is the difference between the two strikes minus the cost to enter the trade. This value is 64.50= (100 – 35.50).

What happens:

• The day after purchasing the put spread, the Nifty jumped upward 2.17% to 18,053.

• At this point, the 17,650-strike long put option purchased for 127.60 is now worth 19.85.
• In addition, the 17,550-strike short put option that was sold for 92.1 has also moved down in value to 15.2 from 19.85.

• The trader still believes that the market will have a downturn so they continue to hold.
• The next several days see the Nifty fall in the trader’s favour. On expiration of the put spread, the Nifty closes at 17,639.55 which is below the upper strike price of 17,650.

The Trade Results:

• The purchased put option that had a strike of 17,650 is in the money by 10.45. You purchased this option for 127.60 so this leg of the strategy has a profit of -117.15
• The sold put option is worthless at expiration because the underlying price is above the contract’s strike price. The profit for this leg of the strategy is 92.1 which is the credit the trader received when they initially shorted the put option.
• You can calculate the loss by adding the ending profits of the two legs of the strategy: -117.15 for the long put and +92.10 for the short put. The trader had a loss of -25.05. 
• A second way to calculate the profit is by using the break-even point. We knew that the trader needed to have the Nifty at or below 17,614.50 in order to turn a profit. Since the Nifty closed at 17,639.70, if we subtract 17,639.70 from 17,614.50, we will also get the loss of -25.05.
• While the trade didn’t turn a profit, it also still didn’t hit the max loss. The maximum loss would have occurred had the Nifty not crossed below the upper strike price of 17,650.

Results compared to Long Put:

• If the trader instead only purchased a long put at the 17,650-strike, this would have cost them 127.60. The break-even price would have been 17,522.40.
• Since the Nifty closed at 17,639.70 on expiration, the put option would have had an intrinsic value of 10.30. The intrinsic value for this put option is the difference between the 17,650-strike and the closing price of 17,639.70.
• Since the option is worth 10.30 but was purchased for 127.60, the loss would have been -117.30.

Scenario 3 – Underlying is above the strike at expiration

The Situation: 

• The trader is bearish on the Nifty which is trading at 17,532.05.
• The trader decides to enter into a put spread with options that have a 1-week until expiration.
• The trader purchases the 17,550-strike for 135.30 and sells the 17,350-strike and receives a premium of 61.05.
• The net cost to enter this strategy is 74.25.
• The break-even is when the Nifty is at 17,475.75. This is calculated by adding the net cost of -74.25 to the upper put option strike of 17,550. To break-even, the Nifty needs to fall by 0.32% from its current price.

What happens:

• The day after purchasing the put spread, the Nifty moved upward by 0.91% to 17,691. 
• The trader decides to hold and the next day, the Nifty moves upward more by 0.74% to 17822.
• At this point, the long call’s value has dropped from 135.30 to 14.20. To buy back the short call would only cost 6.50. 
• The trader decides to hold until expiration as the Nifty closes at 17,790.35.

The Trade Results:

• The bear put spread is deep out-of-the-money and has no intrinsic value at expiration
• This trade results in a loss of the original premium paid of 74.25.

Results compared to Long Put:

• If the trader instead only purchased a long put at the 17,550-strike, this would have cost them 135.30. The break-even price would have been 17,414.70.
• This trade would have also been unprofitable. The difference is that the trader would have lost 1.8X as much with the long put because the put spread only cost 74.25 compared to the long put’s cost of 135.30.

To Conclude: 

• Execute a Bear put spread strategy when you believe that the price of the underlying will move down, but not too much.
• Buy a put option at one strike price and sell another put option at a lower strike price to construct this strategy. Both options should have the same expiry date.
• The combination of buying and selling of a put option reduces the net cost of entering this strategy as compared to a long put trade.
• The maximum payoff from a Bear Put Spread is the difference between the two strikes.
• The maximum profit from this strategy is the difference between the two strikes minus the net cost to enter the trade. 
• The maximum loss is capped at the price you paid to enter the strategy.
• As compared to a spread, trading long puts is a simpler strategy, but it requires larger downward movements in the underlying stock or index to be profitable.

Key Formulae

• Break-even Point = Higher Strike – Net Cost of Strategy
• Long Bear Put Spread Payoff = Higher Strike Price – Lower Strike Price
• Long Bear Put Spread Profit = Higher Strike – Net Cost of Strategy

This concludes our chapter on Long Bear Put Spread strategy. As the name suggests, this strategy is best used in a bear market.