The stock market spends a majority of its time in a bull market. We already know this much as fact. But that doesn’t mean that short-sellers don’t play an important role in the market’s dynamics and that bears can’t benefit from a decline in the market. Taking it a step further, individual stocks and ETFs can make wide-ranging moves, even when the overall market doesn’t exhibit that type of volatility on the surface. That allows bearish option plays to profit for short-sellers who trade options, whether that’s bear put spreads vs. bear call spreads or otherwise.
When it comes to options strategies — for both bulls and bears — there’s no shortage of choices. Without sounding too wishy-washy, that can be both an advantage and disadvantage at times. The disadvantages can be in play when it comes to making a quick decision. Should we do something mellow, like a covered call, or step it up a notch with a bear put spread?
Of course, using OptionParty can help in this regard, as the platform breaks down all the probabilities in the blink of an eye. But for traders in general, we can suffer from decision paralysis when trying to make real-time decisions. (That’s why we do so much of our homework when the market is closed!)
In other cases, these choices can work in our advantage. They allow us to leverage various strategies to use what works best for the situation rather than something that will “just get the job done.” In this case, we’re looking at bear put spreads vs. bear call spreads. Both are bearish options strategies and both will theoretically benefit from a decline in the underlying asset.
Bear Put Spreads vs. Bear Call Spreads
Both strategies are similar in the fact that they are bearish setups, but they differ in their requirements. Bear put spreads are looking to benefit from a notable move lower and involve taking on a net debit, meaning the trader pays to take on the position. In most cases, the bear put spread needs to have the underlying price move lower in order to generate a profit.
The bear call spread differs as it is a net credit trade rather than a net debit. More so though, the strategy differs most in what is required by the underlying stock. Unlike the bear put spread, the bear call spread doesn’t need the underlying security to decline in order to show a profit. In fact, the underlying security can oftentimes trade flat and still leave the bear call spread profitable. Further, the underlying asset can actually rally at times and still leave the the bear call spread profitable. I would say this is one of the biggest difference in the bear put spreads vs. bear call spreads debate.
Another key difference? When we enter a bear put spread we know the maximum profit potential. If we enter a $5 spread with a cost basis of $1, we know our maximum profit is $4. While we know the potential, we do not know what the profit will be until we exit the position. With the bear call spread though, we collect our maximum profit right from the get go. The credit is ours to manage from that point on, but we won’t make more than what we collect once we open the trade.
So which one should you choose? Well, that depends.
Bear Put Spreads
Bear put spreads involve buying one put option and selling a lower strike put option of the same expiration. This creates the spread and in order to be profitable, we need the underlying stock price to decline. To find our break-even points, we first need to determine the cost of the spread. Then, add that to the long put option’s strike price.
For instance, say we are bearish on shares of ABC, which is trading at $77. We buy the $75 put option for $2.00 and sell the $70 put option of the same expiration for $0.80. The trade can be put on for a net debit of $1.20. However, we need more than $1.20 decline in ABC. Specifically, we need ABC to fall below the long strike price $75 plus the net debit. So just to break-even, we need ABC to close below $73.80 on expiration.
Below this mark is when ABC will start to show a profit, up to $3.80. If it falls below $70, our gains are capped at this figure, as we are short the $70 put option. While this requires a large decline in ABC, the nice part is that we have a defined risk; we can’t lose more than the net debit we paid. In this case, that’s $1.20.
Bear Call Spreads
Let’s look at how we could take on a short bias in ABC in the bear put spreads vs. bear call spreads debate. With shares at $77, perhaps we consider the $80-$85 bear call spread. Meaning we short the $80 call and buy the $85 call of the same expiration to limit our potential losses.
In this case, we sell the $80 for $1 and buy the $85 for $0.15, receiving a net credit of $0.85.
Those who do not like credit spreads will quickly point out that this leaves investors exposed to $4.15 in potential risk. That realized if ABC closes at or above $85 at expiration. For this risk, the trader is only receiving $0.85 in compensation. That doesn’t sit well with many investors, as they do not like the potential risk that could bite them on an unexpected move.
That said, those who opt for the bear call spread instead of the bear put spread do not need to see a big decline in the stock in order to collect a profit. In fact, ABC wouldn’t even need to decline in this scenario. As long as ABC closes below $80 on expiration, the trader would collect their full profit.
Up until $80.85, the trade is profitable. At this level, the trade breaks even and above $80.85, the trade turns into a loss. This is a key difference in the two strategies.