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Bear put spreads explained

This article, bear put spreads explained, does just that. We’ll take a look at some examples of bear put spreads, understand how they work, the risks and rewards, and under what kinds of circumstances they work the best.

Bear put spreads explained

A bear put spread involves buying a put option at a strike price that is typically just out-the-money and at the same time selling another put option with a lower strike price so even further out-the-money. Both options are in the same underlying stock or Exchange-Traded Fund, i.e. ETF and have the same expiration date.

Related to this subject, here is an article that explained bull call spreads.

How put spreads work

The situation described above, when we are long a put option with the higher strike price and short an option with a lower strike price will cost money to set up. The put we are buying with the higher strike price costs more than the put we are selling with the lower strike price. The net difference is the cost to us of setting it up.

This is also called a debit put spread because we pay for it. It is a bearish position because it increases in value as the price of the underlying stock or ETF declines.

Let’s consider first how each put option in a bear put spread works. The easiest way to look at this is with a simple example.

Natural gas prices

Let’s imagine it is February and we have a friend who is a meteorologist. He tells us that the forecasters have got it all wrong and so did Phil, the groundhog from Punxsutawney and winter will end soon and the weather will warm up.

You think oil and natural gas prices will drop as it warms up more than most traders are expecting so you think there will be a reaction and the stock prices of oil and natural gas companies will drop. You like the look of making a bearish play on the First Trust Natural Gas ETF symbol FCG and you think this will play out before the third week of March.

I am making this up by the way, just for illustration.

I’ll say that again. This is a hypothetical situation. Nothing written here should be taken as a recommendation to buy or sell any particular kind of financial security or derivative.

Let say you see the stock is currently trading at $14 a share. You think it could get as low as $12 so a 14% drop. There are a few ways you can approach this.

Sell short the stock

The classic approach is to sell short the stock. Here is an article that explains how short selling works.

Let’s imagine that we wanted to take a $1,000 position. Assuming our account is approved for short-selling, we would sell short 71.48 shares in FCG at $14 a share. Currently, the only broker that offers short-selling of fractional shares is Interactive Brokers, but that could always change.

Assuming we are correct and all goes as planned, by about the third week of March FCG shares have dropped to $12 a share. We instruct our broker to close out the position. The broker buys 71.48 shares of FCG at $12 a share and our account shows a credit of $142.86. So there is our gain of just over 14%.

This is what the return on our short stock position looks like on a chart. We are ignoring the impact of charges and fees.

Return on a stock short-sell

Buy a put option.

Another thing we could do is buy a put option. The put option that would be the most sensitive to this price move would be a March monthly with a strike price of $14. We check the options board for FCG and find that the March monthly $14 strike put option is trading with a mid-price of $0.75.

Again assuming that our account is approved for options trading we purchase 13 options at $75 each (100 x $0.75) for a total of $975.

We wait a few weeks, sweat it out as the weather does strange things maybe but again magically by the third week of March all has gone to plan and FCG is now trading at $12 a share. Our put options are suddenly worth $2.00. Assuming that this happens before the end of the week we close out our position of 13 put options for $2,600.

So we made a profit of 167%

This is how the value of our put option tracks the value of the underlying stock in FCG at expiration.

Return on a long put option

Buy a put spread

There is something else we could do to either reduce the cost of or position or if we choose, increase the leverage. In addition to buying a put option that is at-the-money, we could sell a put option in the same underlying stock, i.e. FCG with the same expiration in March at a lower strike price.

The obvious option to check would be the March monthly, $12 strike put. We see it is trading with a mid-price of $0.22. This is what the return on the option would be when plotted against the price of the underlying FCG at expiration.

Return on a short put option position

The net effect of adding the short put position to our long put position is effectively merging the two returns. This is what that looks like.

Return on a put option debit spread

And now for some simple math.

To establish a bear put spread we need to sell the same quantity of puts with the lower strike price as the ones we buy at the higher strike price. So the price of our spread is $0.75 – $0.22 or $0.53. Under these circumstances, we could choose to buy 19 put spreads at $53 each (100 x $0.53) for a total of $1,007.

Considering the same outcome, we would get the maximum from this put spread if the price of FCG reaches $12. In that case, our spread is worth $2  So our total value at expiration would be $3,800 or a total return of a very considerable 277%.

Practicalities

We’ve considered some fairly ideal outcomes in the above scenarios. I can assure you that in practice, these results are the best achievable but this will happen from time to time.

In reality with option spreads, you tend to end up closing a position once the spread has achieved 75% or 80% of the maximum value. That is especially if there is still a long time to run to expiration or if the price is hovering close to the lower strike price.

However, if the price plummets below the level of the lower strike price and you have the stomach to wait it out, you will be able to squeeze every last cent out of a spread if you let it run past expiration.

Profit cap

Something that a bear spread does is place an upper limit on the profit potential. In the case above, if the price of FCG had dropped even lower say, to $10 a share let’s look at the returns for each of the approaches.

The short-sold stock would have returned 29%.

The single long put option would have been worth $4 at expiration against a cost of $0.75, Which comes out at a very substantial 433%.

The bear put spread on the other hand would still have returned 277%. This is because it doesn’t matter how low the price of the underlying stock, in this case, FCG falls below the lower strike price. If that happens your long put position and your short put position increase in value by the same incremental amounts thus canceling each other out.

Another way of saying this is that the maximum value of a bear put spread at expiration is the value of the difference between the strike prices. That also means your profit is the difference between the premium you paid and the spread between the strikes.

Different strokes

So it really comes down to what you are trying to achieve and the timeframe you anticipate. With options, you are always paying a premium for time to expiration on options you are buying. That also means you will be collecting premium on any options that you sell.

Options carry premiums based on the length of time to expiration and the market’s view of the volatility of the underlying stock between now and expiration. This factor is called the implied volatility.

Here is an article the explains implied volatility.

Debit or credit

As you might have guessed there are different ways to set up spreads. The spreads we have been looking at here, which are technically vertical spreads, have one option that costs us money and another option that pays us money.

When we buy a put with a higher strike price and sell one with a lower strike price we pay the net difference and that is a debit spread.

When we buy a put with a lower strike price and sell one with a higher strike price we are paid the net difference and that is a credit spread.

A debit put spread is bearish while a debit call spread is bullish.

A credit put spread is bullish while a credit call spread is bearish.

Credit spreads behave a little differently than debit spreads.

Credit vs debt vertical spreads

As we noted here and in the previous article on bull call spreads, the maximum value at expiration is the width of the spread and the maximum loss is the cost of the spread.

With a credit spread your maximum gain is the premium, you receive your maximum loss is the width of the spread less the premium you received.

One major issue with credit spreads is the risk of being assigned either at expiration if you let it go that far or before expiration. This can be problematic especially when the price of the underlying is between the strike prices. Much will depend on how your broker handles it.

A bear put spread as a hedge

Another use of a bear put spread is to hedge against a sudden market decline.

Let’s look at a bear put spread on the Standard and Poor’s 500 index-tracking Exchange-Traded Fund, or ETF symbol SPY.

Let’s imagine we have a portfolio of stocks with a little bit of cash worth around $100,000 that behaves more or less like the overall market. Or put that another way, we notice that our portfolio tends to move in concert with the Standard and Poor’s 500 index.

Let’s imagine also that the markets are nervous and getting spooked by rumblings about the Fed jacking up interest rates or some other source of market anxiety, like investor exhaustion. We think that a market correction is on the way and we think a 10% drop in the S and P 500 index is on the cards.

We know if that happens we could expect our portfolio to also lose around 10% so a $10,000 drop. However, we also expect that if the market does drop 10% it will come back. Now that might take 6 months or so but generally, our long-term position is bullish.

One thing we can do is set up a bear put spread on the SPY that would create a cash position of about $10,000 if that expected market drop of 10% actually happens. Then when we are confident that the decline has stopped and prices start moving back up, we would have cash available to buy more shares in strong stocks that we like.

Market jitters

Turning the clock back to 12 October 2020, this is just the sort of situation we could think we were facing. SPY closed at $350.13. At that time November monthly puts, which would have 39 days until expiration would have these prices:

  • $350 strike put, $11.81
  • $345 strike put, $9.42
  • $340 strike put, $7.35
  • $335 strike put, $5.60
  • $330 strike put, $4.16
  • $325 strike put, $3.02
  • $320 strike put, $2.13
  • $315 strike put, $1.45
  • $310 strike put, $0.96

This is what the recent price action looked like at that time.

SPY price 13 July to 12 October 2020

1)Source: Historical price data: Yahoo Finance, options calculations: Basic Options Calculator – Powered by IVolatility.com, all charts, and calculations by Bad Investment Advice

Using this information we could model a number of different put spreads, each with a $350 upper strike but with a different lower strike price and all for November expiration. Each of these spreads would have a different cost and a different maximum return.

Unlike with stocks where we are now able to purchase fractional values, we can only buy or sell options in whole numbers. So while we can get close to the $10,000 level of protection, often it will not be exact.

If we plot the maximum returns vs the cost of the spreads, this is what that looks like.

Bear spread prices

Now we have to decide how much downside protection we want and how much we are willing to pay for it. But to avoid juggling with too many variables, let’s imagine we stick with our original intention and seek to hedge for a full 10% drop in the S and P and in our portfolio. So SPY would drop from $350 to $315.

So what we want to do is buy the right number of these spreads so that we would have about $10,000 in cash ready to buy cheap stocks. Here is how much each of the possible put spreads we are considering would cost and how many of them we would need.

Bear spread returns comparison

As we can see the lowest cost approach to getting $10,500 worth of protection would be to purchase three SPY November 350/315 put spreads. This would cost us a total of $3,108. In fact, it is only marginally less expensive than three single put options with a $350 strike price at a cost of $3,543.

Of course, there are other less aggressive approaches that would give us less protection. We might review the situation and decide that a 5% drop is more likely. If that were the case then we would more likely purchase two or three November 350/330 spreads.

You will see there are so many ways of creating a hedge, even when just considering one options strategy that you really have to think through what it is you are hedging against.

Anyway, let’s assume for the moment that we did set up three November 350/315 debit put spreads in SPY. Let’s see what happened through to the end of the year.

SPY price 13 July to 30 December 2020

We can see that SPY did drop to close at $327 about 2 November. In fact, it dropped to a low of $322.60 on 30 October, but the chances of us catching that are honestly slim.

Let’s assume that we were able to exit at the closing price of $327 on 2 November. At that point, with 19 days to expiration, our spread would have been worth $20.57. So our position would now be worth $6,171. We should remember that we paid $3,108 so we have gained $3,063

If we had just bought three November 350 puts instead of doing a vertical spread, then our three puts would now be worth $7,860. Let’s remember that we paid $3,543 so we are up by $4,317.

As we can see, with this particular setup, closing our position on 2 November would be about the best we could possibly do at this point. From here on the market and SPY climbed straight back up again to new highs.

What happened?

A few things happened.

Firstly our anticipation of a 10% drop might have been overdone and the market actually dropped by 6.6%.

Something else that happened between 13 October and 2 November is that implied volatility of the market increased. We can see this in the VIX index which went from 26.07 to 36.13. This meant that the premiums and hence the extrinsic value of options had increased in that time interval.

This would have affected the value of each of our option positions but in different proportions. At this point in time, our long put has $23 of intrinsic value while our short put is still out-the-money and only has extrinsic value.

The combined effect of

  • the increase in volatility,
  • that the price of the underlying SPY is between the two spread strike prices, and
  • that there are still 19 days to expiration,

means that the extrinsic value of the short put is having a downward effect on the net value of our position.

A more judicious choice … perhaps

With the wisdom of hindsight, we should look at what would have happened if we had set up a position with four November 350/325 debit put spreads.

That would have cost us $3,516. On 2 November, that would have been worth $6,580. Again this would be of less net value than three long November 350 put options and the reason is that the short option with the $325 strike price is worth a hefty $9.75 even though it is still $2 out-the-money.

You could argue that we would have been better off just taking a long position in three November 350 strike puts at a cost of $3,543. Except that we would have lost more if our whole prognosis was wrong and the market had just kept on climbing from mid-October through November.

What this tells us about bear put spreads

I think there are a few takeaways from this analysis.

Firstly you really want to be sure that the value of the short option, and therefore the premium you receive does significantly cut into the cost of the long option. Ideally for a put debit spread you want the cost to be somewhere around at least 35 or 30% or less of the value of the spread. In other words,

if you are paying around $3 or $3.50 for a $10 spread that would typically be a good setup. This means that your breakeven point is closer to the higher strike price and there is more room for the option to be profitable.

If we look again at the 350/340 we see that the cost of that $10 spread was $4.46. Let’s imagine that we were anticipating a $10 drop in the price of the SPY. Each November 350/340 debit put spread would have cost us $446 instead of spending $1,810 on a single November 350 put option.

If we had gone this route, once the SPY hits $340 our spread would be worth up to $1,000. Let’s say we got as far as 26 October when the SPY had dropped to $339.39. There would have been 26 days until expiration. Our November 350/340 put spread would have been worth $591 so a gain of 32%. On the other hand, our straight November 350 strike put option would be worth $1,795 so a gain of 52%.

But let’s not completely abandon the idea of bear put spreads altogether. If the price of SPY had dropped to $340 in the third week of November, our November 350/340 put spread would have been worth $1,000 and returned 124% whereas the simple November 350 put would still have returned 52%

So clearly bear put spreads work best if the price of the underlying stays close to the lower strike price.

If we are going to be exiting spreads before expiration to lock in profits, then changes in implied volatility, and therefore the extrinsic prices in the two options comprising the spread play a big role.

Depending on how you set up your vertical spreads, you will often find yourself closing out the positions before expiration when the spread has done what you want it to do just to lock in profits.

Here is an article that explains bear call and bear put spreads.


Questions and answers


Q. Are put options bearish?

A. Put options are bearish when you buy them. In other words, you take a bearish position, hoping or expecting that the market will drop if you take a long position in a put option. On the other hand, selling a put option is a bullish, or neutral position.


Q. Is a put spread bearish or bullish?

A. A debit put spread is bearish while a credit put spread is bullish. In a debit put spread you take a long position, i.e. you buy the put option with the higher strike price and you take a short position, i.e. you sell the option with the lower strike price.

In a credit put spread you do the reverse. You take a long position, i.e. you buy the put option with the lower strike price and you take a short position, i.e. you sell the put option with the higher strike price.

The put option with the higher strike price will always be more in-the-money or less out-the-money than the put option with the lower strike price. So the value of the put option with the higher strike price will always be higher than the value of the put option with the lower strike price.


Q. Is a bear put spread riskier than a bear call spread?

A. Some would argue that a bear put spread is less risky than a bear call spread because the assignment risk with a bear put spread is more manageable. If you are assigned with a bear put spread then your broker can always use the stock from the higher strike put to cover the stock required by the lower price and hence short put.


Single-page summary

Here is a single-page PDF summary of bear put spreads.

Bear put spreads explained summary


I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion, or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons, and share it with your friends. They may just thank you for it.

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Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as personalized investment advice, good or bad. You should check with your financial advisor before making any investment decisions to ensure they are suitable for you.


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References

References
1 Source: Historical price data: Yahoo Finance, options calculations: Basic Options Calculator – Powered by IVolatility.com, all charts, and calculations by Bad Investment Advice

Andy

26 Comments

  1. You dealt with this and I continue researching how a producer can use a bear put spread to hedge in contrast to a falling market. As happens with a put option, the bear put spread can safeguard a price (to a certain point) without having to give up the commodity. While spreads have restricted gains, the lesser the cost of the bear put spread can help the producer cover more production for the same cost.

    • Hi and thanks for your comment. Yes, this is very true. This article looks at bear put spreads from the perspective of the investor and trader rather than from the perspective of a commodity producer. But as you rightly point out there are good reasons for commodity producers and commodity purchasers to use bear put spreads as well. Best regards, Andy 

  2. This is a very comprehensive post on bear put spreads and you have certainly explained it very well. I did not realise that options are part of ETFs, I thought ETF’s consisted of only shares, so you have clarified several things for me. The PDF summary is very useful to see what bear put spread is at a glance. It sounds to me as if trading in options are too risky and volatile for me. 

    • Hi and thanks for the comment. ETFs are composed of shares but many ETFs also have options that can be traded on them. So in this case the options are derivatives of the ETF in question. When you say you didn’t realize that ETFs could contain options, I think you are referring to something else. There are ETFs that include options and potentially other derivatives in their composition. In other words in addition to holding stocks, bonds and commodities, some ETFs also hold options. Such ETFs are often referred to as Buffered ETFs because they seek to buffer themselves against adverse market moves as a form of downside protection. As is always the case though, downside protection comes at a cost.  Best regards, Andy 

  3. I really like the advice of Bear spread. It makes me think of buying shares in the stock market for a very low price, but having NO RISK to doing so. If only that was a true thing in business. And I also like how informative you are about the Bear Spread technique, Your eye candy on the site is quite inviting too! It will keep visitors engaged within the site!

    • Hi and thanks for the positive feedback. I am glad that you found the article informative. Best regards, Andy

  4. This is an awesome description of how Bear put spreads can work. I understand from your explanation that you have to have nerves of steel to let it run all the way but still if you are pulling out at 75% you are trading well and not in too much danger. I think you are a very savvy investor and really understand this type of trading.

    Wishing you well in your trading and thanks so much for explaining this to me.

    • Hi and thanks for the positive comment. One observation with bear put spreads I would make is that since the market tends to spend longer in an uptrend and when down trends happen they tend to start rapidly and decline precipitously. So if you are lucky to have put on a bear put spread at the right time you will often find yourself looking for the best exit point and trying to avoid waiting too long and watch the stock shoot back up. But all this depends on general market conditions. Thanks again and best regards, Andy

  5. Hi Andy,

    I think I am starting to pick up. I had no idea at all about stocks investments. You have the patience to explain and set examples for your readers to understand.

    This is the second article that I have read from your posts.

    The first time I read, there were a lot of financial terms that I cannot relate with. I started to check the highlighted terms and I am now gaining knowledge.

    Also your way now of focusing about bear put spreads and how they differ with bear call spreads are much clearer. I just need to read again and again to be familiarized more. In my experience, I understand things more and get other information implied by the writer which I don’t easily get the first time I read.

    I know if I read more, I will get to familiarize with the terms and the process. Who knows, I may invest later.

    Thanks for sharing… Keep that up! 

    We are gaining!

  6. Thank you for this article. It helps to refresh my finance knowledge. 

    The options market is a rather complex subject and not many people know how to deal with it. Your article highlighted the risk of losing 100% of our principal may happen if the hedging did not put in place properly. 

    Very good educational article for us to take note of if we want to venture into options.

    • Hi and thanks for the positive feedback. Yes, the risk with vertical spreads tends to be that you can end up losing the whole position. Good luck and best regards, Andy

  7. Hi there, very interesting article you have there. I have read articles here and there about investing in stocks. But I’ve never heard of bear put spreads so I was very surprised to see that. Is a bear put spread an effective strategy in the long term or is it only a strategy recommended in the short term? 

    • Hi and thanks for the comment. The general consensus is that bear put spreads work best in trading and investing applications in the short-term. That is certainly the way I use them. You really want to catch the right side of volatility for bear put spreads to work well. You have an easier ride if you can sit and watch the extrinsic value of your short put decay faster than any remaining extrinsic value of your long put. Then your spread just increases in value as the expiration date approaches even while the price of the underlying doesn’t move much. Thanks for the question, best regards, Andy

  8. Hello Andy, thank you for this detailed report. I had absolutely no idea about investing in stocks. You have written an excellent article for beginners like me to explain it with creative examples. Thank you so much for that.
    Now, this Bear put spreads is clearer to understand. I have my difficulties, but this is normal as a beginner. Of course, I have to educate myself more to behave correctly in this thematic. It is so easy to lose a lot of money if you commit the wrong one. I will continue to visit your website to familiarize myself with this fascinating topic.

    Best regards, Monique

    • Hi Monique, bear put spreads is definitely not a topic suitable for people who are starting out investing. As you point out it is easy to lose money since these kinds of options strategies involve very high leverage. I wish you the very best of luck and thanks for the comment. Best regards, Andy

  9. Hi @Andy,

     That’s a very informative piece. I personally love buying shares in the stock market when the price is low and in turn sell when high. Bear put spread seems like a better way to try and multiply my initial investment. But, this doesn’t necessarily mean all will be well and good when trading bearish. It’s important to consider the Bullish aspect of the market

    Awesome article. I will definitely share with my friends!

    -Sergej

    • Hi Sergej

      Thanks for the positive comment. I agree with you that trading on the bearish side tends to be riskier than trading on the bullish side in most markets. Market declines tend to happen quickly and reverse back up even more rapidly. So to be successful on the bearish side often requires you to be more nimble.

      Good luck with your investing and trading

      Best regards

      Andy

  10. Hi Andy
    Thanks for sharing your review on bear put spreads. This was really comprehensive article and you explained everything in detail about bear put spreads. I found PDF summary to be very useful and it projected the content idea in a very precise manner .You did a thorough research to write this article and I hope it’s going to help a lot of people.
    Thanks and regards,
    Gaurav Gaur

    • Hi Gaurav

      Thanks for your positive comment. I am glad you found it interesting and useful.

      Best regards

      Andy

  11. Hi, I really love how you explain so many strategies and how much knowledge and understanding you have regarding trading, ETF’s, Options and more. Again, I read your articles but still I am struggling to understand anything to do with trading. I think it is one of those things where it’s not for everyone. I wish I could understand so clearly how trading, options, ETF’s and all the different strategies work. Maybe one day my mind will comprehend. Who knows?

    • Hi. I think it is fair to say that trading and investing are more a question of attitude and approach to building personal wealth. Most people consider themselves investors because building wealth over the long-term is what most of us are looking for. So anyone with a savings account or even a house that they live in is an investor. Trading is really investing in the short-term. At the extreme end, trading can become speculating. It is all a question of how we look at it. There are many more articles here like this one that focus more on investing over the long-term. Best regards, Andy

  12. Hi Andy, I’ve just gone through your article on bear put spreads explained. I find it very informative and interesting. Sometimes investing can be very challenging, but, with this amazing article I’ve just read, I find it now simplified. Thank you for sharing such helpful information with us. I promise to use this strategy for my investments. And I will be visiting your site often to learn more about good investment advice.

    • Hi Kokontala, thanks for the positive comment. I am glad that you found the article interesting and informative. Good luck with your investing. Best regards, Andy

  13. Thanks for the very interesting text and very detailed explanation, with plenty of examples and charts of how Bear put spreads work. I was familiar with some other trading techniques and other trading tools but I did not know this. I was very interested and I will definitely try it.

    • Hi and thanks for the comment. I would be very careful with bear put spreads. I hope I made this clear in the article but usually, and particularly in the current conditions market declines happen very rapidly and reverse very rapidly. Good luck and best regards, Andy

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