Table of Contents
Options Strategies – Bear Put Spread
Spreads versus naked positions
Most professional options traders prefer initiating a spread strategy versus taking on naked option positions. There is no doubt that spreads tend to shrink the overall profitability (max profits), but at the same time spreads give you a greater visibility on risk (max loss).
Always remember “Professional traders value ‘risk visibility’ more than the profits.”
It’s a much better deal to take on smaller profits as long as you know what would be your maximum loss under worst case scenarios.
Another interesting aspect of spreads is that invariably there is some sort of financing involved, wherein the purchase of an option is funded by the sale of another option. In fact, financing is one of the key aspects that differentiate a spread versus a normal naked directional position.
Bear Put Spread Strategy
The Bear Put Spread is quite easy to implement just like Bull Call Spread. A bear put spread is implemented when the market outlook is moderately bearish
Here whole point is that you have probability that its ‘moderately bearish’, a 4-5% correction would be possible and by invoking a bear put spread one would make a modest gain if the markets correct (go down) as expected but on the other hand if the markets were to go up, the trader will end up with a limited loss.
A conservative trader (risk averse trader) would implement Bear Put Spread strategy by simultaneously
- Buying an In the money Put option
- Selling an Out of the Money Put option
There is no compulsion that the Bear Put Spread has to be created with an ITM and OTM option. The Bear Put spread can be created employing any two put options. The choice of strike depends on the aggressiveness of the trade. However do note that both the options should belong to the same expiry and same underlying. To understand the implementation better, let’s take up an example and see how the strategy behaves under different scenarios.
Now say Nifty is at 17480, this would make 17600 PE In the money and 17400 PE Out of the money. The ‘Bear Put Spread’ would require one to sell 17400 PE, the premium received from the sale would partially finance the purchase of the 17600 PE which we buy.
The premium paid (PP) for the 17600 PE is Rs.175, and the premium received (PR) for the 17400 PE is Rs.83/-. The net debit for this transaction would be 83 – 175 = -92
Scenario’s of trading:
1. Market expires at 17800 (above long put option 17600)
This is a case where the market has gone up as opposed to the expectation that it would go down. The premium paid for 17600 PE i.e Rs.175 would go to 0, hence we retain nothing.
The premium received for 17400 PE is Rs.83 would be retained entirely
Hence at 17800, we would lose Rs.175 on one hand but this would be partially offset by the premium received is Rs.83
The overall loss would be -175 + 83 = -92
The net loss of 92 is equivalent to the net debit of the strategy.
2. Market expired at 17600 (at long put option)
Here at 17600 both 17600 and 17400 PE would expire worthless resulting in a loss of -92.
3. Market expires at 17508 (breakeven)
17508 is half way through 17600 and 17400, and as you may have guessed I’ve picked 17508 specifically to showcase that the strategy neither makes money nor loses any money at this specific point.
The 17600 PE would have an intrinsic value equivalent to Max 17600 -17508= 92
We have paid Rs.175 as premium for the 17600 PE
Would be 175 – 92 = 83, which means to say the net loss on 17600 PE at this stage would be Rs.83 and not Rs.175
The 17400 PE would expire worthless, hence we get to retain the entire premium of Rs.83
So we make 83 (17400 PE) and we lose 83 (17600 PE) resulting in a no loss no profit situation
Hence, 17508 would be the breakeven point for this strategy.
4. Market expires at 17400 (at short put option)
The 17600 PE would have an intrinsic value equivalent to Max [17600 -17400, 0], which is 200
We have paid a premium of Rs.175, which would be recovered from the intrinsic value of Rs.200, hence after compensating for the premium paid one would retain Rs.25/-
The 17400 PE would expire worthless, hence the entire premium of Rs.83 would be retained
The net profit at this level would be 25+83 = 108
Here trader gets to make a modest profit when the market goes down.
5. Market expires at 7200 (below the short put option)
Here The 17600 PE would have an intrinsic value equivalent to Max 17600 -17200 = 400
We have paid a premium of Rs.175, which would be recovered from the intrinsic value of Rs.400, hence after compensating for the premium paid one would retain Rs.225/-
The 17400 PE would have an intrinsic value equivalent to Max 17400 -17200= 200
We received a premium of Rs.83, will have to let go of the premium and bear a loss over and above 83. This would be 200 -83 = 117
On one hand we make a profit of Rs.235 and on the other we lose 117,235 – 127 = 108
Overall expectation from the strategy is that the trader gets to make a modest profit when the market goes down while at the same time the losses are capped in case the market goes up.
The losses are capped to 92 (when markets go up) and the profits are capped to 108 (when markets go down)
Strategy makes a loss if the spot moves above the breakeven point, and makes a profit below the breakeven point
Both the profits and loss are capped
Spread is difference between the two strike prices.
In this example spread would be 17600 – 17400 = 200
Net Debit = Premium Paid – Premium Received
175 – 83 = 92
Breakeven = Higher strike – Net Debit
17600 – 92 = 17508
Max profit = Spread – Net Debit
200 – 92 = 108
Max Loss = Net Debit
Note: Delta is our freind. Whenever we implement an options strategy always add up the deltas. The delta of 17600 PE is -0.618. The delta of 17400 PE is – 0.342
The negative sign indicates that the put option premium will go down if the markets go up, and premium gains value if the markets go down. But do note, we have written the 7400 PE, hence the Delta would be0.3420
Deltas are additive in nature we can add up the deltas to give the combined delta of the position. In this case it would be 0.276 adding to – 0.276 = 0
Summary
- Spread offers visibility on risk but at the same time shrinks the reward
- When you create a spread, the proceeds from the sale of an option offsets the purchase of an option
- Bear put spread is best invoked when you are moderately bearish on the markets
- Both the profits and losses are capped
- Classic bear put spread involves simultaneously purchasing ITM put options and selling OTM put options
- Bear put spread usually results in a net debit
- Net Debit = Premium Paid – Premium Received
- Breakeven = Higher strike – Net Debit
- Max profit = Spread – Net Debit
- Max Loss = Net Debit
- Select strikes based on the time to expiry
- Implement the strategy only when you expect the volatility to increase