Bear Put Spread Strategy

In our last chapter, we have discussed Bull Call Spread, a strategy for moderately bullish traders. But what if you are of the view that the market or any particular stock will go down? This is where a Bear Put Spread comes into the picture to help you in benefiting from falling prices with risk-covering. Let's discuss how the Bear Put Spread works and when you can use it to make the most of a bearish outlook.

What is a Bear Put Spread?

A bear put spread is when one buys a higher strike price put option and sells a lower strike price put option on the same stock, having the same expiration date. This strategy lets you profit from a moderate decline in the stock price with limited risk, compared to buying a single put option.

Instead of paying an expensive premium for a single put option, the Bear Put Spread reduces your upfront cost by selling a lower strike put, which makes it cost-effective to bet on the decline of a stock.

How Does a Bear Put Spread work?

Let’s break it down with an example:

Assume HDFC Bank is trading at ₹1,500 and you expect the price to go down. You would initiate the Bear Put Spread by:

1. Buy Put Option with strike price ₹ 1,500 at ₹100 per share premium.
2. Sale of Put Option with Strike Price of ₹ 1,400 at a premium of ₹ 50/- per share.

The strategy's net premium paid is:

• Premium paid for buying the put: ₹ 100
  
• Premium received for selling the put: ₹ 50
  
• Net Premium Paid: ₹100 - ₹ 50 = ₹ 50 per share
  

That means the maximum risk at ₹ 50/- per share and the profit potential is limited but attractive.

Profit Potential

The maximum profit occurs if the stock price falls below ₹1,400 at expiration. Let’s see how:

1. Stock falls to ₹1,400 or lower: You sell the stock at ₹1,500 (higher strike) and buy it back at ₹1,400 {lower strike) and make ₹100 per share. Subtract the ₹50 premium paid, and your net profit is ₹50 per share.

2. Stock stays above ₹1,500: The options expire worthless, in which case your loss will be restricted to the premium that you have paid, that is ₹ 50 per share.

Hence, the profit will be a difference between the strike prices, i.e., ₹ 100 minus the premium paid of ₹ 50, which is equal to ₹ 50 per share.

Why use a Bear Put Spread?

The Bear Put Spread works best in the following circumstances:

1. You are expecting a moderate decline in the stock's price: It's perfect for that situation where you feel the stock will decline but not crash.

2. You want a cheap bearish position: The strategy reduces the cost of one put by selling another with a lower strike.

3. Slow declines anticipated: you want slow, stable dips in price. It best matches stocks that probably will slowly taper down in price.

Risks of Bear Put Spread

The good news is that the Bear Put Spread limits your risk, but there are a couple of disadvantages that come with it:

1. Limited Profit: It limits your upside. Since in our example, the maximum profit available is capped at ₹ 50 per share.

2. Expiration Risk: You might potentially lose the whole premium paid if the stock does not fall enough before expiration.

3. Loss if Stock Stays Flat or Rises: You will lose ₹ 50 per share, if the stock price remains above ₹ 1,500.

When should one consider using a bear put spread?

The Bear Put Spread is best utilized when:

• You expect the stock to experience a moderate decline.
  
• You want to take some bearish position with a cheap price.
  
• You anticipate steady, predictable declines.
  

Conclusion

The Bear Put Spread is an excellent strategy whenever any trader wants to profit through the fall in stock prices and with limited risk. To profit from a moderate decline while limiting your risk, you buy and sell different strike prices of put options. In our next chapter we will discuss another exciting strategy involving multiple options to profit in sideways markets, known as the Iron Condor.