Advanced Strategies for Options - Bear Put Spread

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Advanced Strategies for Options - Bear Put Spread

In the last section we described a bear spread using calls. A more common variation of the bear spread involves the use of puts. Once again a lower strike price is sold and a higher strike price is purchased but because puts are used these transactions create a debit. This is true because a put with a higher strike price will sell for more than a put with a lower strike price.
The put bear spread has the same sort of profit potential as a call bear spread. There is both limited profit potential and limited risk. However, put bear spreads have one important advantage over call bear spreads. When establishing a put bear spread the investor sells an out- of- the money put option. This transaction does not risk early exercise; in fact for the out- of- the money put to be exercised the spread would have to be profitable. This is not the case for call bear spreads. In a call spread the investor sells an in- the- money call as part of the bear spread and thus is at risk of early exercise before the spread becomes profitable.

A second advantage of the put bear spread is that puts tend to lose time value quickly when they go into the money. If the underlying security falls rapidly and both the long put and short put go into the money the investor may be able to collapse the spread before the expiration date. This can be a significant advantage because capital required for the bear spread can then be re-allocated to another transaction.

Now that we have some of the formalities out of the way, let’s examine a case study of a put bear spread.

Once again Maria believes Cisco Systems (CSCO) common stock is likely to decline in the near term. She is reluctant to short sell the stock outright so she chooses to establish a bear spread. With CSCO trading at $100 Maria notices that the December 95 puts are trading at $1.00 and the December 105 puts are trading at $7.00. Maria decides to sell one contract of the December 95 put and buy and one contract of the December 105 put for a net debit of $600.

Let’s examine what happens at expiration

Cisco Systems Share Price at Expiration

Profit for December 95 puts

Profit for December 105 puts

Total Profit

93

($100)

$500

$400

95

$100

$300

$400

97

$100

$100

$200

99

$100

($100)

$0

100

$100

($200)

($100)

103

$100

($500)

($400)

105

$100

($700)

($600)

107

$100

($700)

($600)

As you can see Maria gains her maximum profit when CSCO shares fall to or below $95, the short put strike price. Her maximum loss is her initial debit, this occurs when CSCO shares rise to or above 105, the long put strike price. Maria’s break-even point occurs when CSCO shares reach $99, this corresponds to the higher strike price less the initial debit.

Summary

1. Put bear spreads are preferable over call bear spreads because the risk of early exercise occurs only when the spread becomes profitable.

2. The maximum profit is the difference between the long and short strike prices less the initial debit.

3. The break-even point is the higher strike price less the initial debit.

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Cisco Systems Share Price at Expiration	Profit for December 95 puts	Profit for December 105 puts	Total Profit
93	($100)	$500	$400
95	$100	$300	$400
97	$100	$100	$200
99	$100	($100)	$0
100	$100	($200)	($100)
103	$100	($500)	($400)
105	$100	($700)	($600)
107	$100	($700)	($600)