Bear Put Spread Option Strategy - Detailed Guide and Explanation - 5Paisa

Trading in options indeed sounds like a tough row to hoe. Newcomers in the market have difficulty getting the hang of equity trading, let alone derivatives. But unbeknownst to a lot of new traders, derivative instruments like options are more advantageous over a direct stock or commodity trade. You can enjoy the same rewards as in the case of direct trading of the underlying by trading in options but with a much lower investment and risk. Sounds too good to be true? Let us explain.

By going long on options, you are not under an obligation to buy or sell but have the liberty to opt-out of the trade entirely in case the market expectations do not work in your favour at maturity. For this, you have to pay a premium known as option premium at the time of buying, which also happens to be your maximum possible loss. Derivatives, especially put and call options are a peculiar asset class that can provide considerable diversification benefits to your portfolio.


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Why Have An Options Strategy?

In the case of a vanilla option trade, your maximum loss, as discussed above, is limited to the option premium. But in certain market conditions, you might have to pay a hefty premium to go long on a Put or Call Option. In such a case, you could lower your risk even more by taking a combination of two or more opposite positions, thereby offsetting some or most of the initial outlay. This increases cost-efficiency and lowers your investment significantly. With strong option strategies in place, you can grow as a trader with limited liquidity.

A Bear Put Spread Strategy - What do the terms mean?

A bear market prediction means you expect prices of stocks/commodities or indices to go down. This can be because you foresee geopolitical tensions, an economic crisis or an impending health crisis. A Put option is a contract to sell the underlying at a particular strike price. The term spread derives the value from the difference between the prices of two assets. 

When to Use This Trading Strategy?

The Bear Put Spread can be entered into when your stock/market outlook is slightly or moderately bearish. When you expect a fairly big but limited down move in the prices of your target stock or the index, that is to say.

Risk Profile

This strategy encompasses a limited risk and a limited reward for you as a derivative trader. You take two contradictory positions, which creates a substantial hedge. This is advantageous as the risk to reward ratio is considerably low (stay with us to understand why!).

How Do You Trade to Create a Bear Put Spread?

Since the market outlook is assumed to be bearish, you would BUY one Put Option and, on the other hand, SELL or write a Put Option. 

For the Put BUY, you would pay a fixed premium and for the SALE, receive a premium. As the premium outflow would be higher than the inflow, your net option premium would stand as a debit. This is why this strategy is also termed Bear Put Debit Spread.

When it comes to the strike prices, ideally, the Put Option is to be bought ATM (At The Money) and sold Out of the money (OTM). 

But why?

Let's Take A Simple Example and Talk in Numbers

Say the Nifty is currently trading at 17200. To create this spread, you Buy One Put Option ATM, that is, at a strike price of 17200 by paying a premium of 200 rupees. Simultaneously you sell another Put Option at a strike price of 16800 (OTM) by receiving a 100 rupees premium. So your net expenditure for premium stands at Rs. 100.

Now, three months later:

Scenario 1: Nifty Trades at 16500

For the Put BUY, there is a gain of 700 (Strike Price - Current Market Price). Against the Put SALE, there is a loss of 300 (CMP - Strike Price). The resultant payoff or inflow from this trade would be 300 (Net Profit of 400 - Net Premium of 100).

Scenario 2: Nifty Trades even lower at 16300

For the Put BUY, there is a gain of 900 (Strike Price - Current Market Price). Against the Put SALE, there is a loss of 500 (CMP - Strike Price). The resultant payoff or inflow from this trade would again be 300 (Net Profit of 400 - Net Premium of 100).

Scenario 3: Nifty Trades at 17000

For the Put BUY, now there is a gain of 200 (Strike Price - Current Market Price). The buyer will not exercise the Put SALE as the CMP is higher. The resultant payoff or inflow from this trade would be 100 (Net Profit of 200 - Net Premium of 100).

Scenario 4: Nifty Trades at 17400

None of the options would be exercised in such a situation as the CMP is higher than both the strike prices. The Net Payoff or Outflow would be only the Net Premium Debit which is 100.

So, in each of the two Scenarios 1 and 2, the maximum profit from this position stands at INR 300. This will hold even if you bring the maturity date market price further down. 

In the case of an opposite price movement, like in Scenario 4, the maximum loss would be limited to the net premium amount, INR 100. It is interesting to note that this maximum loss is substantially lower than the premium outflow in the case of a naked put buy which would have amounted to INR 200.

And, in the third possible scenario (as in Scenario 3), where the price ends up anywhere between the two strike prices (Above 16800 and below 17200), the net payoff from this trade will vary accordingly. Still, it will always be restricted within the upper and lower capping. In our example, there was a positive payoff of Rs. 100.

Here's a Table That Reflects The Different Positions for the Possible Scenarios

Probable Prices of Nifty at Maturity Profit/(loss) on Long Put (Strike Price: 17200) Profit/(loss) on Short Put (Strike Price: 16800) Net Payoff (that is net of premium outflow of 100)

16300

900

(500)

300

16400

800

(400)

300

16500

700

(300)

300

16600

600

(200)

300

16700

500

(100)

300

16800

400

 (Expires worthless)

300

16900

300

 (Expires worthless)

200

17000

200

 (Expires worthless)

100

17100

 (Expires worthless)

 (Expires worthless)

(100)

17200

 (Expires worthless)

 (Expires worthless)

(100)

17300

 (Expires worthless)

 (Expires worthless)

(100)

17400

 (Expires worthless)

 (Expires worthless)

(100)

To put all that together

When the Bear Put Spread matures, irrespective of the maturity prices -

Max Loss: Net Premium (Premium paid for Buy - Premium received for Sale)

Max Profit: Difference in Strike Prices less Net Premium

Break-Even: Strike Price of Buy less Net Premium

Let us weigh the Pros and Cons of the Bear Put Spread.

The Upside

  • It is cheaper than a naked put, as the net premium gets fairly reduced from the inflow

  • You pay only for the limited down move in price that you are anticipating

  • Lower Theta and IV Risk

  • Since there is an offsetting position, the margin to be paid is also lower

  • Lower risk to reward ratio than a naked long put trade

The Downside

  • Profit is limited and capped at the difference in strike prices net of premium

  • Not ideal if the markets are extremely volatile 

  • Returns are not great if the prices eventually have a very big or long down move

More often than not derivative traders jump into options trading without awareness or knowledge of the strategies available at their disposal. Sometimes the value of derivative assets does not move commensurately with the movement of the prices of the underlying.

Options contracts are vulnerable to market volatility and sentiments. It becomes imperative to constantly monitor and calibrate the strategies in tandem with the market trends, conditions, volatility and other relevant factors. Strategising proactively with appropriate combinations of trade facilitates:

  • Heavy returns even with a lower risk appetite.

  • Make the best of market opportunities that suddenly become attractive.

  • Make strong bets with smaller investments.

  • Hedge the risk exposure significantly.