Back to Basics: The Bear Put Spread
We’re all quite familiar with the basics of options trading – at least, if you’ve found yourself using Option Party for its advanced tools and probabilities, you likely know that buying call options are bullish, while buying put options are bearish.
However, too many new investors opt to buy “naked” calls and puts, or single leg positions that expose them to too much risk and not enough reward. That’s why options spreading is an important tool that’s key to many successful traders’ playbook.
Recently we covered bull call spreads, which involves buying a lower priced call option and selling a higher priced call option expiring in the same month. The bear put spread works in a similar manner. However, the bull put spread involves buying a higher priced put option and selling a lower priced put option expiring in the same month.
For example, a bear put spread would look like this:
Buy 1 ABC April $45 put option for $2.00 debit
Sell 1 ABC April $40 put option for $0.75 credit
Net debit: $1.25
Owning just the $45 put option gives investors a potential reward of $43 in total, (the strike price minus the net debit; $45 – 2 = $43). However, that would require shares of ABC falling to $0 by April expiration.
That’s where the mindset of “unlimited reward” is misleading. Technically, this theory only exists for call options, because stocks have no limit on how high they can go. While that’s true in theory, it’s not true in reality. Every stock has a price, and it’s not infinity.
For put options, the maximum reward is limited to the strike price minus the net debit, because a stock cannot be valued at less than $0. But even in this case, it’s uncommon for a stock to go from the mid-$40s to $0 in such a short period of time.
Even catastrophic news for a stock may “only” show a drawdown of 50% to 80% at the extremes before some sort of buyer materializes. I do not mean to imply that a 50% loss is not significant – it is – but falling from $45 to $22.5 is still significantly higher than $0.
Putting It All Together
So what is the point of all of this? This is essentially to say that focusing on one’s risk – more times than not – is more important than focusing on one’s reward. By spreading our options, we can still position ourselves to reap a handsome reward, while simultaneously lowering our risk.
Look at our example above. If we bought just the $45 put, our maximum risk is $2.00. In order to see a profit, we need shares to fall below $43.
However, by selling the $40 put option, we reduce our net debit to $1.25 from $2.00 – a reduction of nearly 40%. Additionally, our break-even price goes from $43 up to $43.75. So now we need shares of ABC to fall less in order to see our position show a profit, while simultaneously lowering our risk.
What Are We Sacrificing?
By selling the $40 put, we are effectively capping our gains at that level. If shares of ABC fall below $40 on expiration, we will not be able to profit below that level.
Assuming the stock is below $40, our maximum profit will be $3.75. That profit figure is derived by the difference in the two strikes ($45 – $40 = $5), minus our net debit ($5 – 1.25 = $3.75). This would represent a gain of 300%, which is nothing to scoff at.
By selling the put, we are sacrificing theoretical profit. But let’s be realistic. If shares of ABC are trading at-the-money – so $45 in this case – a decline to $40 would represent an 11.1% drop. That’s a pretty notable decline in a stock, although hardly unheard of.
By selling the $40 put, we sacrifice potential, but also lower our risk and improve our break-even. Let’s say the stock ends at $42 on April expiration. Here’s what our results look like under each scenario:
Own the $45 put for net debit of $2.00; Breakeven: $43
$45 put minus $2.00 debit = $43; minus $42 stock price = $1.00.
Total Profit: $1.00
Own the $45/$40 put spread for net debit of $1.25; Breakeven: $43.75
$45 put minus $1.25 debit = $43.75; minus $42 stock price = $1.75
($40 short put expires worthless)
Total Profit: $1.75
As you can see, owning the $45/$40 put spread not only lowered our risk, but because of our lowered break-even price, our profit actually increased by 75%.
A Real Life Example
We’ve seen what a put spread looks like in practice, but what about in the real world? Let’s use OptionParty’s screening tools to find ourselves a true example of a bear put spread.
Generally speaking, this would take quite a bit of time. First, we’d have to go through each stock’s option chain, hunting for the right setup. Then, we’d need to find a reasonably priced trade. Thanks to Option Party’s proprietary scanning methods though, this task takes only seconds.
Party Rank sorts out the best trades for us, so all we have to do is tell the system what we’re looking for.
United Airlines UAL and American Airlines AAL were the top two choices. Depending on the risk/reward appetite of the particular investor, they may opt for one over the other.
Investors can also play their odds by entering both positions. The AAL trade has a higher return on risk and lower total-loss probability. However, it’s probability of success – target return probability and probability of profit – are both lower than the UAL trade.
Taking a closer look at the AAL trade, it involves buying the April $49 put option while simultaneously selling the April $45 put option. Currently, the stock is trading near $41.50, so the put spread is already in-the-money. So long as the share price closes below $45 at the time of expiration, our trade will realize its maximum profit.
While some traders may appreciate the higher odds of success with UAL, they may not appreciate its higher potential for total loss. In the end, it is up to a trader to decide.