Bear Put Spread

Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. For this bearish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. Also since the higher strike premium is higher than the lower strike premium this is a debit spread.

Market Opinion? Moderately Bearish to Bearish

When to Use?

Moderately Bearish

An investor often employs the bear put spread in moderately bearish market environments, and wants to capitalize on a modest decrease in price of the underlying stock. If the investor's opinion is very bearish on a stock it will generally prove more profitable to make a simple put purchase.

Risk Reduction

An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long put alone, or with the conviction of his bearish market opinion.

Chart: Bear Put Spread

Benefit

The bear put spread can be considered a doubly hedged strategy. The price paid for the put with the higher strike price is partially offset by the premium received from writing the put with a lower strike price. Thus, the investor's investment in the long put and the risk of losing the entire premium paid for it, is reduced or hedged.

On the other hand, the long put with the higher strike price caps or hedges the financial risk of the written put with the lower strike price. If the investor is assigned an exercise notice on the written put, and must purchase an equivalent number of underlying shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace. The premium received from the put's sale can partially offset the cost of purchasing the shares from the assignment. The net cost to the investor will generally be a price less than current market prices. As a trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy.

Risk vs. Reward

Downside Maximum Profit: Limited

Difference Between Strike Prices - Net Debit Paid

Maximum Loss: Limited

Net Debit Paid

A bear put spread tends to be profitable if the underlying stock decreases in price. It can be established in one transaction, but always at a debit (net cash outflow). The put with the higher strike price will always be purchased at a price greater than the offsetting premium received from writing the put with the lower strike price.

Maximum loss for this spread will generally occur as underlying stock price rises above the higher strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost.

The maximum profit for this spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money. This will be the case no matter how low the underlying stock has declined in price. If the underlying stock is in between the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its intrinsic value. The written put will be out-of-the-money, and have no value.

Break-Even-Point (BEP)?

BEP: Strike Price of Purchased Put - Net Debit Paid

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in either the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay?

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the written put, profits generally increase at a faster rate as time passes.

Alternatives before expiration?

A bear put spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit.

Alternatives at expiration?

If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the puts.

If only the purchased put is in-the-money and has value as it expires, the investor can sell it in the market place before the close of the market on the option's last trading day. On the other hand, the investor can exercise the put and either sell an equivalent number of shares that he owns or establish a short stock position.

Bear Call Spread

When the market is volatile and you are moderately bearish on it, you might consider a Bear Call Spread. This strategy involves selling a call option at one strike price and buying a call on the same asset at a higher strike price (further out-of-the-money). Usually both options will have the same expiration date. This is also referred to as a Bearish Credit Spread.

This strategy has a profit/loss picture that is similar to a Bear Put Spread, however in this case, there is a net premium that goes into your trading account when you establish the position, whereas with the Bear Put Spread, you are paying out a premium when you establish the position. Like the Bear Put Spread, this strategy has limited risk but also limited profits.

This strategy is a bearish strategy, like selling naked calls, that places premium into your account when you establish the position. However it limits your risk by the purchase of lower priced calls, protecting you if the price goes up significantly.

With this strategy, your potential profit is limited to the premium you collected for the calls you sold less commissions and the premium you paid for the calls you bought. Your potential losses are limited to the difference between the strike prices multiplied by 100 times the point value of the contract, less the cost of establishing the position. An option calculator such as Option-Aid performs these calculations for you instantaneously.

When we initiate a Bear Call Spread, the call we buy has the same expiration date, with a higher strike price (at a price point that we feel sufficiently limits our risk, without significantly lowering the premium we are collecting.

It is also important to cover risks and caveats of this strategy.

The risk of this position is limited and known risk as described above. Remember that the commission you pay for this position will be higher than the commission for a straight option play, because you are initiating two related option transactions.

When you initiate a Bear Call Spread, you are limiting your upside potential. If the asset price drops significantly, then you aren't able to fully participate in that gain like you would if you had purchased a put.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Selling Calls

When you are bearish on the market and feel confident that it won't rise in the short term, you might consider selling calls to generate additional income. When you hold the assets for which you are selling the calls, then they are covered calls and there is limited risk. If you do not hold the assets, you are selling naked calls and your risk is unlimited, although your profits are limited. You must be careful when selling naked calls.

With this strategy, you are selling someone the right to buy an asset at a fixed price (the strike price), on or before the expiration date of the option. It is a bearish strategy or bearish directional strategy. You are a call writer (selling the call).

This strategy has some nice benefits.

You receive a premium for selling someone the right to purchase an asset at a particular price that you feel it will stay below. If the asset price is below the strike price at expiration, then the calls that you sold are not exercised and the premium that you collected provides additional income for you, increasing your rate-of-return. If you are writing calls or out-of-the-money calls, the asset may continually increase in value, yet the options may never get exercised, allowing you to do this over and over again. This generates continuous income for you, increasing your portfolio and generating cash flow for other investments.

If the calls that you sold do get exercised, then you are obligated to sell the asset at the exercise price. But you essentially sell the asset at a premium from the asset price that existed when you sold the calls, because you collected the option premium. You have already agreed that you would like to sell the asset at the exercise price and the price is augmented by the option premium that you collected.

Since you are the seller of the option, the time decay of the option works in your favor. The time-value portion of the call premium constantly declines with time, going to zero on the expiration date. The rate of decay is predictable and is easily calculated by options analysis programs such as Option-Aid. As the expiration date approaches, the rate of decay increases. For this reason, it is often better to sell calls with one month or less until expiration. After they expire, you can sell calls on the next month out and collect another premium if you still have the same view of the market at that time.

It is also important to cover risks and caveats of this strategy.

If the asset price rockets skyward and stays above the strike price at expiration, then the option will probably be exercised and you will be obligated to sell the asset at the agreed-on strike price or cover the option, incurring a loss. If you sold naked calls, your risk is unlimited.

It is important to analyze your expectations for the underlying asset before selling the call. If you expect the asset price to remain stable, you can write the call approximately at-the-money and collect a larger premium. If you sell an in-the-money call, the premium you collect will be even larger, but you run a greater risk of the option being exercised.

Long Put

A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying puts and holding put options.

When to Use?

Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying security. This investor is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long puts can offer than in the number of contracts purchased.

Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased is the more bearish the strategy, as bigger decreases in the underlying stock price are required for the option to reach the break-even point.

Benefit

A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited risk versus the unlimited upside risk from a short stock sale. Purchasing a put generally requires lower up-front capital commitment than the margin required to establish a short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits.

Risk vs. Reward

Maximum Profit: Limited Only by Stock Declining to Zero

Maximum Loss: Limited
Premium Paid

Upside Profit at Expiration: Strike Price - Stock Price at Expiration - Premium Paid
Assuming Stock Price Below BEP

The maximum profit amount can be limited by the stock's potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid.

Break-Even-Point (BEP)?

BEP: Strike Price - Premium Paid

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a higher stock price.

Volatility

If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect

Any effect of volatility on the option's total premium is on the time value portion.

Time Decay?

Passage of Time: Negative Effect

The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.

Alternatives before expiration?

At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss.

Alternatives at expiration?

At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to purchase an equivalent number of shares in the marketplace, exercise the long put and then sell them to a put writer at the option's strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account.