A put option is a financial derivative that gives the buyer an option to sell the underlying asset at a fixed price any time before the expiry of contract to the seller. When a trader speculates the security price to fall, they tend to choose a put option. A bear put spread is a form of options strategy where an investor anticipates a considerable decline in the price of a security and follows the bear put spread to bring down the cost of holding the option.
How does it work?
To make this work, a trader buys a number of put options at a higher strike price while also selling the equivalent number of puts of the same security with the same expiration date at a reduced strike price. The profit is calculated by finding the difference between the two strike prices, minus the total cost incurred to buy the options. A bear put spread is also called ‘long put spread’ or ‘debit put spread’.
As the name suggests, the cost of the put option is “spread” between two transactions. When you sell the put option that has a lower strike price, it covers some of the cost incurred in buying the put option with a higher strike price. As a result, the total spend is relatively less than buying a single put option.
Spread the cost
When a trader projects the price of security to fall moderately after some time, then he prefers to go for a bear put spread. It is, in fact, an attempt to strike a balance between the risk and reward of making money on declining share prices.
For example, let us assume that ABC company’s shares are trading at ₹100 per piece. You want to buy a ‘put’ option since you project the stock price to fall. But instead of buying only ‘put’ options, you spread your cost by buying a ₹80 put, at a premium of ₹4, and selling a put with strike price of ₹60, where you collect a premium of Re 1. Both the options are set to expire simultaneously. Buying the two options reduces the total cost of buying the options to ₹3 ( ₹4 - Re 1).
In this case, if your projection turns out to be wrong and the stock closes above ₹80, you will incur loss to the tune of ₹3 per share. And if the share closes at ₹60 or lower, the profit will stand at ₹80 – 60 - 3 = ₹17 (difference between two strike rates minus total cost of both options). Also, the breakeven point would be ₹80-3 = ₹77.
To summarise, a trader can make money by spreading the cost of put options and thereby minimising the risk at the same time. One can do this by buying a put option at a higher strike price, and selling the put option of the same security at a lower strike price in a bid to cut down on the cost of holding the option.