Basic Options Strategies: Bear Put Spread (Vertical Spread) - Part Two
Continued From Part One...
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.
To Be Continued In Part Three...
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