Master the Bear Put Spread: Profit from Market Declines

This course equips you with the Bear Put Spread strategy, ideal for capitalizing on anticipated stock or index price drops.

In simple terms, you'll strategically combine Put Options to profit when your target falls below a certain price. This approach offers defined risk and reward, making it a powerful tool for bearish traders.

While the Bear Put Spread has a lower probability of success (30-50%), the potential payoffs can exceed 200%!

This comprehensive course covers:

Through videos, PDFs, quizzes, and assignments, you'll gain practical experience and confidence. You'll also have access to a demo account to practice implementing the strategies learned.

Get ready to profit from falling markets with the Bear Put Spread!

The bear put spread is made up entirely of put options on the same underlying stock (or index). It’s constructed by purchasing a put with one strike price and selling (writing) another put with a lower strike price but the same expiration month. The ratio of long puts to short must be 1:1. The result is a position consisting of a long put (higher strike) and a short put (lower strike). An investor with this position can be said to be long a bear put spread, or in more casual terms to be long a put spread.

Before diving in, it's important to know that Bear Put Spreads are debit spreads. This means you'll pay a net debit (cash outflow) to establish the position.

What are Spreads?

Simply put, a spread combines long and short options of the same type (call or put) on the same stock or index. It has two "legs":

This combination creates a defined risk and reward profile.

Types of Spreads:

We'll mainly focus on vertical spreads, which are the most common type.

Debit vs. Credit Spreads:

Bear Put Spreads are always debit spreads because the higher-strike put you buy (long leg) costs more than the lower-strike put you sell (short leg).

This upfront debit represents the maximum risk of the trade, while the potential profit is limited to the difference between the strike prices minus the net debit paid.

By understanding these concepts, you'll be well-prepared to learn how to effectively utilize Bear Put Spreads in your trading strategy.

See put options quote for SPY below for the March 17th expiry (4 months to expiry). The share price of SPY is currently $225.45

To establish a bear put spread with SPY options, we might buy 1 SPY March 17th $225 put for $6.74, and at the same time sell (write) 1 SPY March 17th $220 for $4.82.

The result is the investor holding 1 SPY March 17th $225/$220 bear put spread, at a $1.92 ($6.74– $4.82) net debit or $192 total. This is one of the first benefits of the bear put spread versus buying the put. See matrix below:

The bear put spread is a bearish position. We expect to profit from a decrease in its price.

However, it’s a moderately bearish position since we generally expect SPY to decrease down to or slightly below the $220 short put’s lower strike price by expiration. Below that level, the profit is capped. A more bearish investor might simply buy puts outright or short the stock.

Since we are only moderately bearish on SPY, the cost of buying the $225 put at $694 might represent more upside risk than we are willing to take. By selling the lower $220 strike put also and taking in premium, the cost of the $225 long put is reduced. This premium will at least partially offset a loss on the $225 long put if we are incorrect and SPY goes up instead. The trade-off for protecting some of the $225 long put’s value in this manner is of course the limited downside profit potential.

The maximum downside profit for a bear put spread is limited to the difference between the puts’ strike prices, less the debit initially paid for the spread. In our example, this profit will be seen if the SPY closes at or below the lower $220 strike price of the short put at expiration, no matter how low SPY declines.

In our SPY $225/$220 bear put spread example, the maximum profit is:

$5.00 strike difference ($225-$220) – $1.92 (debit paid) = $3.08, or $308 total.

If at expiration SPY closes at or below the lower (short put) strike price of $220, then the maximum profit would be realized. This is probably the only downside of the bear put versus the long-put. The long-put has unlimited profit potential whereas the bear put spread has limited profit potential. See matrix below:

The maximum upside loss for a bear put spread is limited entirely to the net debit initially paid for it. This loss will be seen if SPY closes at or above the $225 higher strike price of the long put at expiration, no matter how high the SPY increases.

At expiration, if SPY closes at or above the higher strike price of $225, both put options would expire with no value, and the net $1.92 debit paid for the spread would be lost.

Maximum loss = $1.92 debit paid, or $192 total

This is a real benefit of the bear put spread versus the long-put strategy. Our risk is lower. See matrix below.

The return on investment formula is simply:

(Max profit potential / Max Loss) * 100

Looking at our SPY example:

{$308 (Max Profit) / $192} * 100

= 160.4%

I think you will agree that this return on investment is substantial. It is difficult to make a direct comparison with the long $225 put strategy as the long-put strategy has unlimited reward. But if we were to compare strategies based on the share price falling to the lower strike price of $220 at expiration you would make a loss on the $225 long put but would make the maximum profit on the bear put spread.

The break-even price for a bear put spread at expiration is a closing SPY price equal to the $225 higher strike price of the long put minus the $1.92 debit paid for the spread.

For the SPY $225/$220 Bear Put

= $225 higher strike – $1.92 debit paid

= $223.08

This is another major advantage of the bear put spread over the long-put strategy. The share price of SPY doesn’t have to fall as much from its current level of $225.45 to start making a profit at expiration. See matrix below:

One of the major drawbacks of the long-put strategy was the probability of profit at expiration. Because the break-even price of the bear put spread is higher, the probability of profit will also be higher. Remember, the share price of SPY was at $225.45 for this example. With the long put the share price needs to fall to $218.26 or below to start making a profit at expiration. In the case of the $225/$220 bear put spread, the share price must only fall to $223.08 at expiration to make a profit. That is why the probability of profit is higher for the bear put spread.

In the SPY example, the probability of profit for the long $225 put is 38%. But the probability of profit for the $225/$220 bear put spread increases to 45%. See matrix below:

Note: This probability is still not high (by our standards) but it’s better than the long-put strategy. If implied volatility was higher we would prefer to place a bear call spread. But when implied volatility is low and we believe a share price will fall to a certain level, the bear put is the best strategy to apply.

At expiration, if SPY closes at a point between the break-even price and either of the two strike prices, either a partial loss or partial profit would be seen. Below the break-even price there would be a partial profit; above the break-even point there would be a partial loss.

Before expiration, an investor can take a profit or cut a loss by selling the spread if it has market value. This involves selling the long put and buying the short put, which will be done at a net credit, and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid for the spread and the credit received at its sale.

Here is an example of a P&L table for the SPY March 17th $225/220 Bear Put Spread. Remember we paid $1.92 for the spread:

The financial impact of a change in volatility depends on whether one or both puts are in-the-money and the amount of time until expiration.

Theta is the rate of decay in the time value of an option. For a bear put spread, if SPY is closer to the $225 higher strike of the long put, losses should increase at a faster rate as time passes. Conversely, if SPY is closer to the $220 lower strike of the short put, profits should increase at a faster rate with time. Look at the option quotes again:

The SPY March 17th $225/$220 bear put spread we have two positions to consider.

Delta is the rate of change in the value of an option for a $1 move in the underlying share price. In our example with the SPY $225/$220 bear put spread, we have two positions to think about.

This means that the value of the SPY $225/220 bear put spread will go up by $0.128 per share or $12.80 total for a $1 fall in SPY and vice versa.

We can also consider delta as being short 12.8 shares of SPY. Think about it...if SPY rose by $1 and we were short 12.8 shares we would lose $12.80. The exact same as the SPY $225/220 bear put spread.

A couple of things to know about delta:

Some bear put spreads can be considered more bearish than others. The degree of bearishness depends primarily on the strike price of the short put, which determines how low the underlying stock (or index) needs to decline for maximum profit to be realized at expiration.

Remember, when you reduce risk, profits will be lower.

Remember, when you increase risk you have less chances of being profitable. But rewards are also higher. You must make the trade-off between risk and reward.

Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money.

For an equity put option, early assignment generally occurs when the short put is deep in-the money, expiration is relatively near, and its premium has little or no time value. If a bear put spread holder is assigned early on the short put, then he may exercise his long put and sell shares purchased per the assignment obligation. In this case, maximum profit on the bear put spread would be realized.

If early assignment is received on the short put of a bear put spread, the cash settlement procedure for index options will create a debit in the investor’s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises his long put the cash settlement amount credited to his account will be determined at the end of that day. There is a full day’s market risk if the long option is not sold during the trading day assignment is received.

The action you take at expiry will depend on where the share price is trading at:

We much prefer the bear put spread over the long-put strategy as the risk is greatly reduced because the sale of the lower strike put reduces the cost and risk of buying the long put. Also, you have a better chance of making a profit.

We use the bear put spread in the following scenarios:

If we are bearish and implied volatility is high we will choose credit type strategies such as the bear call spread.

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