Bear Put Spread
A Bear Put Spread is a type of option strategy that can be used when the price of an asset is expected to moderately decrease. It involves selling (writing) a put option at a lower strike price and buying one put option at a higher strike price. It is a strategy with less risk than just buying a put option or when you are only moderately bearish.
Characteristics
Some of the benefits of the Bear Put Spread are that your loss is limited, however the pay off to limit your loss is that your profit is limited as well. The maximum profit is limited to the difference between the two strike prices minus the net premium paid for the position. The maximum loss is limited to the difference between the two strike prices minus the net paid for the position.
Theoretical Example
When buying a put option, we attain the following payoff. Point C is the initial loss, that is, the amount you pay for the put option. Once the share price passes below point B, your loss reduces. If the share price continues to fall, it will then move into profit territory.
When writing a put option the net effect is the following. As the share price is falls you still have a constant profit (Point C) up to Point A, when your profit reduces. If the share price keeps falling, you begin to lose money.
Putting the bear put spread together gives the following payoff diagram. The maximum amount of profit you can make is Point C and the Maximum loss that you could incur is Point D.
When would this strategy be used?
This strategy would be used in a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock, that is, not a large fall. If you thought the share price would fall substantially it would be better to buy just a put option.
