Bear put spread, also called long put spread or debit put spread, consists of a long put option with higher strike price and a short put option with lower strike and same expiration. The "long" in the name refers to the long position in the more valuable, higher strike put option – not to exposure to underlying price direction, which is bearish (makes money when underlying goes down).
Like other vertical spreads, bear put spread has limited risk (equal to net initial cost) and limited profit potential (strike difference minus net initial cost).
Setup
Bear put spread consists of two put options with the same expiration date, one long and one short. To create a bear put spread:
- Buy a put option (more on strike selection below).
- Sell a put option with lower strike, on the same underlying, with same expiration date.
Two important things define a bear put spread:
- Both options have the same expiration date.
- The short put has lower strike than the long put (otherwise it would be a bull put spread – the inverse strategy).
Cash Flow
Bear put spread is a debit strategy. Its initial cash flow is negative, because the higher strike put which we are buying is more expensive than the lower strike put which we are selling (put options are more expensive with increasing strike price). The latter helps finance the cost of the former, but it never pays for it completely.
Initial CF = short put price – long put price
Payoff at Expiration
Like with other vertical spreads, there are three possible scenarios at expiration:
Maximum Loss
Maximum loss occurs when underlying price is at or above the higher strike. Both put options expire worthless. Total result from the trade equals initial cash flow, which is negative.
Maximum Profit
The best case scenario is when underlying price ends up at or below the lower strike. Now both puts are in the money. Their values are the respective strikes minus underlying price, so the difference between their values (net payoff from the entire spread) equals the difference in strikes. Net profit equals this strike difference minus initial cost.
Break-Even Point
If underlying price ends up between the two strikes, the trade results either in a profit or loss. Only the long higher strike put option is in the money; the short put expires worthless. The key is whether the payoff from the long put (higher strike minus underlying price) exceeds net initial cost of the position. If it does, the trade makes a profit.
Therefore, bear put spread break-even point is:
Long put payoff = net initial cost
Higher strike – B/E underlying price = long put initial price – short put initial price
B/E = higher strike – long put initial price + short put initial price
Below the break-even the position makes a profit; above it makes a loss.
For more details and examples of payoff calculation, see Bear Put Spread Payoff, Break-Even and R/R.
When to Trade
The considerations when trading a bear put spread are similar to bull call spread, only with the direction reversed – bearish instead of bullish.
The strategy is suitable when we expect a moderate decrease in underlying price. Its profit in case of further fall in underlying price is capped by the short lower strike put. Beyond the lower strike, the two put options offset one another and total profit is constant.
When we expect a bigger fall in underlying price, we can either choose a bear put spread with lower strikes or strikes wider apart (more on strike selection below), or not sell the lower strike put at all and just buy a put option.
Strike Selection
Like with other vertical spreads, selection of strikes for the two put options has significant effects on risk, profit potential, and exposures to time and volatility.
We can break down the strike selection decision in two parts:
- Where = Which strikes relative to current underlying price.
- How wide = How big distance between the two strikes.
With the first decision we have three possibilities:
- Both strikes below current underlying price (out of the money).
- Both strikes above (in the money).
- Long strike above (ITM) and short strike below (OTM).
These result in very different exposures – almost like completely different option strategies!
The logic is again similar to bull call spread, only in the opposite direction.
Both Strikes below Underlying Price
If we choose both strikes below underlying price when opening the position (#1), both puts are out of the money. Their premiums are lower. The difference between premiums (net initial cost and maximum possible loss from the spread) is also smaller.
That said, with both options out of the money, we need underlying price to move and get below the long put strike and our break-even, for the position to be profitable. If underlying price stays the same until expiration, we will lose.
In other words, we want volatility (we need price to move), while time works against us.
A bear put spread with both strikes below current underlying price has positive vega (long volatility) and negative theta (short time). This is because the long higher strike put option is closer to the money and has greater time value than the short lower strike put, which means greater time decay.
Both Strikes above Underlying Price
Conversely, if we choose both strikes above the current underlying price (#2), both options are in the money and more expensive. The difference in premiums is greater, and so is our net initial cost and maximum possible loss.
However, now we don't need underlying price to move for the position to be profitable at expiration. Both options are already in the money, so we only need to wait and hope that the market doesn't go against us. We are long theta (passing time is good) and short vega (volatility is bad).
Unlike the previous case, now the short lower strike put is closer to the money and has greater time value than the long higher strike put (the latter is more expensive overall, but the time value portion of its premium is smaller). Therefore, the short put option will lose time value faster than the long put, and the combined position will become more valuable with passing time.
Underlying Price between Strikes
Probably the most popular type of bear put spread is with the long put in the money (higher strike above underlying price) and the short put out of the money (lower strike below underlying price).
In terms of initial cost, time and volatility exposure, it is somewhere between the two previous cases. It can be either long volatility and short time (if the higher strike is closer to underlying price and the long put has greater time value than the short put), or the opposite (if the lower strike is closer).
For neutral exposure to time and volatility (so the strategy is mainly focused on underlying price moves), it is best to choose two strikes which have the current underlying price approximately in the middle.
Of course, these characteristics only apply when opening the position, or as long as underlying price doesn't move. When it does, the relative time values of the two options will change, and so will the combined exposures to time and volatility.
Strike Distance
Another decision to make is how far apart the two strikes will be. It affects the risk and profit potential of the spread.
With strikes wider apart the position has greater initial cost, greater risk, but also greater potential profit.
The more conservative you are, the closer together the two strikes should be.
As the two strikes approach one another, the two put options are getting closer to being identical, so the cost, risk, and potential profit from the spread approaches zero.
Summary
- If you are more bearish or expect greater volatility, choose lower strikes.
- If you expect lower volatility, or expect the underlying to "not rise" rather than "fall", choose higher strikes.
- If you want the position neutral on time and volatility, choose both strikes approximately the same distance from current underlying price.
- If you are conservative, choose strikes close together.
- If you can risk more, and want more profit potential, choose strikes further apart.