Bear Put Spread

 It involves buying and selling put options at two different strike prices that expire on the same date.

Adin Lykken

Reviewed by

Adin Lykken

Expertise: Consulting | Private Equity


September 15, 2022

A bear put spread is an options strategy that requires multiple legs. It involves buying and selling put options at two different strike prices that expire on the same date. The bear put spread is considered to be an advanced options strategy.

In this type of put spread, the investor's long put option has a higher strike than their short put. The price to enter the trade is the difference between the premium paid for the long put option and the premium collected for selling the short put option. 

Because investors begin to see returns once the long put is fairly in the money, choosing this strategy demonstrates a mildly bearish outlook on the underlying stock. It can also be said that the spread as a whole has a net negative delta. 

Compared to a simple long put, which reflects a more bearish outlook, this strategy is considered to be mildly bearish because the short put position caps the profits. 

Investors can think of the short put leg as strategic in the sense that it raises the break-even point (meaning that the price must drop less) and decreases the maximum possible loss on the trade. 

This is because the investor gains value from the passage of time due to the short put option instead of only losing time value from holding a long put. 

Furthermore, the typical risk associated with holding a naked short position is covered by the long position

The main things to remember about the bearish version of a put spread are the following:

  • The strategy reflects a mildly bearish outlook rather than a completely bearish one
  • The investor pays a premium to enter the spread 
  • Both losses and profits are capped

Relevant Options Details

When trading using advanced options strategies such as spreads, investors must have a strong understanding of the core components of options contracts. However, beyond just the basics, this strategy hinges on a strong understanding of the options of the greek delta. 

For any given options trade, there is both a long and short position. For a given put option, these two positions have the following rights and responsibilities:

  1. Long position - Right to sell
  2. Short position - Selling/fulfillment obligation

Traders on the buy side of a put option pay a premium to purchase the contract. Ownership of the contract gives the buyer the right to sell 100 shares of the underlying security at the strike price at or before the expiration date (varying slightly depending on the type of option). 

On the sell side of the trade, the seller writes the contract and collects the premium from the buyer. In return, they take on the risk of the trade. 

In this case, the risk is a fulfillment obligation to the buyer. The obligation is to purchase the shares of the underlying stock from the buyer of the contract for the specified strike price up until the contract's expiration date. 

Because the bear put strategy involves both buying and selling put options at different strike prices, each leg of the contract gains or loses value at different rates. 

In an option contract, the greek delta tells us how much the premium of the option contract changes for each dollar shift in the price of the underlying stock. 

Call options have a positive delta, and put options have a negative delta. This is because call options gain value with a price rise, while put options decline in value with a rise in price.

For options contracts sold, we reverse the delta. This is because the goal for sellers is a worthless contract expiration. Increasing the premium would mean repurchasing the contract, and closing the position is more expensive. 

We look at the net delta for an option strategy with multiple legs, such as the spread we created. This tells us how the price of the spread changes overall, with respect to changes in the underlying. 

Because the long put position has a higher strike, the delta will be of a greater magnitude. For put options, price decreases in the underlying have more likely to impact the higher-strike option than the lower-strike option. 

As we can see in the option chain for VOO, strikes closer to the last price of 375.21 have a higher magnitude delta than the highlighted 355 strikes on Oct 21, 2022, put option. This highlighted put a delta of -.29, for example, while the 375 put is -.47.

Because the second leg is a short put, we reverse the sign of the negative delta and are left with a positive value for this leg. Because this strike is lower, it will always be farther from the money or less in the money than the long position. 

This means when we add the two deltas together. The long put negative delta outweighs the short put positive delta. Therefore, the resulting spread has a net negative delta. This means that, for the seller, the spread gains value overall as the underlying stock price falls. 

Bear Put Spread Example

In this example, bear put spread. The investor is purchasing a put at a 100 strike and selling a put at a 95 strike. Both options are expiring in 30 days, and the pricing model assumes implied volatility of 30. The current price of the underlying is $100.

As we can see, the cost for the long position is roughly $334.58. This cost is higher than the total premium collected for selling the 95 strike option, which earned the investor around $137.68. This leaves the investor with a net cost of around $196.90. 

Looking at the profit and loss graph, the mildly bearish outlook becomes apparent. For the investor to break even, the stock price must have a moderate fall to just over $98. 

The amount the stock must fall to break even is equivalent to the original premium of the spread, which is expressed on a per-share basis. 

Note that the premium is 1/100th of the total cost, as this contract controls 100 shares. The net premium the investor paid was around $196.90, meaning the stock must fall $1.97 to break even. 

Break Even = Long Strike - Net Spread Premium

The max loss also relates to the premium, as the premium determines the price to enter the position.

Max Loss = Spread Price = Premium x 100

The premium also determines the max profit but includes the distance between strikes. 

Max Profit = (Long Strike - Short Strike) x 100 - Spread Price

We can see exactly why each of these specific price points makes sense by looking at different expiration price scenarios. 

Consider a situation where the price at expiration rose to $105, which is above the strike price of the long position. 

The investor's long position expires worthless. It is not exercised. The investor's short position also expires worthless. It is not exercised. This means that the investor is left with a loss equivalent to the net cost of the two contracts, around $196.90.

As we can see, this loss is less than that of a simple long put trade, which would be an alternative bearish setup the investor could construct.

Instead of losing the full $334 for entering only the long position (as shown in the graph), the investor has offset part of their losses by selling the 95 put. 

Another possibility is the underlying strike price at expiration is in between the two strikes, in this case, between 100 and 95. Let's say the closing price is $98. 

In this situation, the long put is in the money and gets exercised. The investor buys 100 shares for the market price of $98 and uses the put option to sell them at $100. The investor makes $200 from the 2-dollar price difference. 

The short put is out of the money, so the investor has no fulfillment obligation. Considering the net cost of the two contracts, the investor is left with a profit of about $3.10. 

Compared to the long put counterpart, the investor using the bear put spread is more profitable once again. If the investor had only purchased the 100 puts, they would fail to break even on the trade, as the contract price is greater than the market and strike price differential at expiration. 

The outcome is one where the market price of the underlying is below the short put strike option, in this case, below $95. Let's assume that the market price is $90. 

Because both puts are in the money, they are both exercised. As a result, the investor who purchased the spread cannot take advantage of the full price difference between the market price and their long put.

The long put is exercised, meaning the investor can sell 100 shares at the $100 price point. However, because the investor sold the $95 put, they are obligated to buy shares from another investor for $95. This difference from the spread leads to $500 in revenue. 

When the investor takes into account the original cost of the trade, they are left with around $303.10 in profit. 

In fact, the thinking is the same at any point below the short put. Below this point, the investor no longer benefits from the price difference between their long put and the market price. Instead, they are liable for 100 shares at their short put strike price and only profit on the difference in strikes. 

For this reason, the investor has capped profits. This is disadvantageous compared to a simple long put at certain price points, as the long put has the potential for extremely large profits. 

In this case, the long put counterpart would have earned much more, around $694.   

Final Considerations

As we can see from the above profit and loss comparisons, the bear put spread is strategic in the sense that it lowers both a trader's maximum loss, break-even points, and maximum profits when compared to a simple long put setup.

Because extreme price movements are less common than smaller price movements, it can be said that the probability of profiting when using a bear put spread is higher than that of a long put. 

Beyond just the differences in the chance of a profitable exit of the trade, the investor has to take into account increased risk and responsibility for having a short leg in their investment strategy.

While it is true that the long put position hedges the risk associated with the short position, the possibility of the assignment before the expiration of the option is possible. 

This is notable in cases where the underlying stock has a divided payment scheduled before the expiration of the put contract. The assignment is likely if the put contract is in the money and has more time value than the expected dividend payment.

If the investor holding the spread is not paying attention, they may not realize that assignment is likely. Forgetting to close their position by closing the entire spread or repurchasing the short leg (leaving the long position open) leaves an investor with fulfillment obligations. 

In this situation, a long position is created on the investor's account. These shares can be either resold on the market, or the long put can be exercised. The account will be liquidated if the account owner does not have enough money to purchase the shares. 

These extra considerations and the complexity of details associated with price movement are vital reasons this strategy is recommended for advanced traders.

Many brokerages will not allow investors to use this strategy without first verifying the investor's familiarity with options and other financial information.

As with all options strategies, a greater degree of risk is associated with increased leverage when using a bear put spread. Beyond just understanding the setup, investors should have an understanding of equity valuation based on fundamentals. 

Feel free to check out our financial modeling course to understand these concepts better. Due diligence in the underlying and a strong conviction of price movement is a must-have when using strategies susceptible to extra volatility. 

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Researched and Authored by Jacob Rounds LinkedIn

Reviewed and edited by James Fazeli-Sinaki LinkedIn

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