Basic Options Strategies: Bear Put Spread Part Two
The bear put spread can be considered a doubly hedged strategy. Theprice paid for the put with the higher strike price is partially offsetby the premium received from writing the put with a lower strike price.Thus, the investor's investment in the long put and the risk of losingthe entire premium paid for it, is reduced or hedged.
On the other hand, the long put with the higher strike price caps orhedges the financial risk of the written put with the lower strikeprice. If the investor is assigned an exercise notice on the writtenput, and must purchase an equivalent number of underlying shares at itsstrike price, he can sell the purchased put with the higher strikeprice in the marketplace. The premium received from the put's sale canpartially offset the cost of purchasing the shares from the assignment.The net cost to the investor will generally be a price less thancurrent market prices. As a trade-off for the hedge it offers, thiswritten put limits the potential maximum profit for the strategy.
Risk vs. Reward
Downside Maximum Profit: Limited to Difference Between Strike Prices - Net Debit Paid
Maximum Loss: Limited Net Debit Paid
A bear put spread tends to be profitable if the underlying stockdecreases in price. It can be established in one transaction, butalways at a debit (net cash outflow). The put with the higher strikeprice will always be purchased at a price greater than the offsettingpremium received from writing the put with the lower strike price.
Maximum loss for this spread will generally occur as underlying stockprice rises above the higher strike price. If both options expireout-of-the-money with no value, the entire net debit paid for thespread will be lost.
The maximum profit for this spread will generally occur as theunderlying stock price declines below the lower strike price, and bothoptions expire in-the-money. This will be the case no matter how lowthe underlying stock has declined in price. If the underlying stock isin between the strike prices when the puts expire, the purchased putwill be in-the-money, and be worth its intrinsic value. The written putwill be out-of-the-money, and have no value.
BEP: Strike Price of Purchased Put - Net Debit Paid
If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies
The effect of an increase or decrease in either the volatility of theunderlying stock may be noticed in the time value portion of theoptions' premiums. The net effect on the strategy will depend onwhether the long and/or short options are in-the-money orout-of-the-money, and the time remaining until expiration.
Passage of Time: Effect Varies
The effect of time decay on this strategy varies with the underlyingstock's price level in relation to the strike prices of the long andshort options. If the stock price is midway between the strike prices,the effect can be minimal. If the stock price is closer to the higherstrike price of the purchased put, losses generally increase at afaster rate as time passes. Alternatively, if the underlying stockprice is closer to the lower strike price of the written put, profitsgenerally increase at a faster rate as time passes.
Alternatives before expiration?
A bear put spread purchased as a unit for a net debit in onetransaction can be sold as a unit in one transaction in the optionsmarketplace for a credit, if it has value. This is generally the mannerin which investors close out a spread before its options expire, inorder to cut a loss or realize profit.
Alternatives at expiration?
If both options have value, investors will generally close out a spreadin the marketplace as the options expire. This will be less expensivethan incurring the commissions and transaction costs from a transfer ofstock resulting from either an exercise of and/or an assignment on theputs.
If only the purchased put is in-the-money and has value as it expires,the investor can sell it in the market place before the close of themarket on the option's last trading day. On the other hand, theinvestor can exercise the put and either sell an equivalent number ofshares that he owns or establish a short stock position.
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