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.
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.
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.
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.
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.
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.
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%.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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