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Bear Put Spread

 

The Bear Put Spread strategy entails doing two things at the same time: purchasing a put on an underlying stock and writing a put on the same underlying stock.

 

Market Opinion

 

Moderately bearish to bearish.

 

P/L

 

Description: http://www.avasaram.com/images/strategies/PLSP/BearPutSpread.png

 

When To Use

 

If the trader or investor believes that they are in a moderately bearish environment, they will use this strategy to take advantage of a decrease in stock price.

 

Example

 

GE is trading at $40 but you think it is under pressure and might go lower. The bear put spread strategy would be to simultaneously buy a $40 put and sell a $35 put. You wold purchase the $40 put for $1.50 and sell a put for $.50. The total spread costs $100 to arrange ($150 minus $50).

 

If GE finishes at $40 or above, all you lose is the $100 because both puts would expire

without value. If GE finishes at $39, you would break even because the long put would be in-the-money by $1 and the other put would be without value. If GE finishes lower than $35, the value of the spread is $500. If GE finishes below $35, those additional gains in the $40 put are offset by the increased value of the $35 short put. So the maximum gain is the $500 net value of the trade less the initial $100 it cost to set up, or $400.

 

Benefit

 

This allows the trader or investor to put into place a double hedge. By receiving the premium from writing the put with the lower strike price, they offset the price they paid for the put with the higher strike price. Also, the put with the higher strike price reduces the risk of the written put if the owner is assigned an exercise notice and has to buy the underlying shares, since the strike price was previously determined.

 

Risk vs. Reward

 

The risk with a Bear Put Spread is that if the underlying stock price increases above the strike price, the whole amount of the net cash outflow, or net debit paid for the bear put spread, will be lost. The reward accrues as the stock price declines.

 

Net Upside

 

Difference between strike prices minus net cash outflow/debit.

 

Net Downside

 

Net cash outflow/debit paid.

 

Break Even Point

 

The break even point for a Bear Put Spread is the strike price of the purchased put minus the net debit paid, or net cash outflow.

 

Effect Of Volatility

 

Volatility effects the time value of the put, and the effects are different for whether the options are in-the-money, out-of-the-money, and the time remaining on the option.

 

Effect Of Time Decay

 

Time decay will be different depending on where the underlying stock price is. If it is between the strike prices, the effect will not be significant. If it is close to the lower strike price, profits will increase at a faster pace. If it is close to the higher strike price, losses will increase at a faster pace.

 

Alternatives Before Expiration

 

A Bear Put Spread can be sold if the trader or investor wants to capture a profit or stem a loss.

 

Alternatives At Expiration

 

If both of the options have value, they will be closed out when they expire. Or the trader or investor can exercise the put and sell the underlying shares or establish a short stock position. If only the purchased put is in-the-money, then it can be sold.

 
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