Intermediate to advanced options strategy knowledge

Views 2657 Oct 31, 2024

Bear Put Spread

What is bear put spread?

This strategy can be broken down into three parts: bear, put, and spread.

  • Bear: This indicates an expectation that the price of the underlying asset will fall.

  • Put: This refers to the type of options used in the strategy.

  • Spread: This involves buying and selling multiple options of the same type (in this case, puts) on the same underlying asset, typically with different strike prices or expiration dates.

Practical Scenarios

● Expect the stock price to drop but not much.

● Already bought a put option but want to reduce the cost.

I. Strategy Explained

1) Setup

Sell Put A」 + 「Buy Put B」

Strike Price of Put A < Strike Price of Put B

Note: We label the options with uppercase letters for clarity. The strike price of Put A is lower than that of Put B.

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2) Breakdown

The potential profit:

Buy Put B: You may profit if the underlying stock price falls.

Sell Put A: This reduces the cost of buying Put B.

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3) Features of Strategy

Favorable Conditions: Bearish. The underlying stock price falls.

Limited Profit: If the stock price falls as expected, selling put A with the lower strike price may limit the maximum profit.

Theoretical Maximum Profit = (Put B strike price - Put A strike price + Net Premium Per Share) * Multiplier * Contract Quantity

Limited Loss: If the stock price does not fall as expected both options will expire worthless and your loss will be limited to the net premium paid.

Theoretical Maximum Loss = Net Premium Per Share * Multiplier * Contract Quantity

Note: While the maximum loss is theoretically limited by the bear call spread structure, investors should be aware that assignment risk, early exercise, or volatile price movements can result in losses greater than the theoretical maximum if the position is altered or closed before expiration. Early assignment could result in the need to buy shares at a higher price, potentially exceeding the premium received from selling Call A. Ensure you understand the assignment and margin requirements of your account before implementing this strategy.

Option Buying Strategy: The primary trading position in this strategy is the long put B, which potentially generates profits if the stock falls as expected.

This is a low-cost bearish option strategy with a limited potential loss. Ideally, it should be considered when implied volatility is low and can benefit from significant price movements afterward.

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II. Case Study

TUTU (a theoretical stock for demonstration purposes only) is a publicly traded company focusing on the artificial intelligence. Through fundamental analysis, you believe that TUTU has reached a short-term peak and its stock price may slightly fall in the near term. Therefore, you buy a put option with a strike price of $58, referred to as put B.

However, buying a put requires paying an option premium. To reduce the cost, you choose to sell a put with a strike price of $50, referred to as put A, creating a bear put spread strategy.

With this strategy, you can potentially profit from the decline in the stock price by buying put B, while reducing the financial input required by selling put A.

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Cost of opening the position:

Premium received from put A: $200 ($2 per share).

Premium paid for put B: -$500 (-$5 per share).

Net premium in total: -$500 +$200=-$300 (-$3 per share).

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1) Scenario 1: Stock price is above put B strike price at expiration

Both put A and put B are out-of-the-money (OTM) and expire worthless.

The maximum loss is achieved, which is the net premium paid when opening the position.

Maximum Loss (Theoretical): Net Premium Per Share * Multiplier * Contract Quantity = ($2-$5)*100*1=-$300

Note: The loss for this strategy is limited (assuming no shares are exercised or assigned). Even if TUTU's stock price rises to $100, the maximum loss is still -$300. However, this is only true if no assignments or early exercises occur.

2) Scenario 2: Stock price is between put A strike price and put B strike price at expiration

The put A is out-of-the-money and the put B is in-the-money (ITM).

Breakeven: Put B Strike Price + Net Premium Per Share = $58+(-$3)=$55.

If the stock price is below $55, the strategy may profit but the profit is limited by the sold call.

If the stock price is above $55, the strategy suffers loss and the loss is limited to the net premium paid.

3) Scenario 3: Stock price is below put A strike price at expiration

Both put A and put B are ITM and maximum profit is achieved in this case.

Maximum Profit (Theoretical): (Put B strike price - Put A strike price + Net premium per share) * Multiplier * Contract quantity

Note: In bear put spread, net premium is often negative (cash outflow).

Put A assigned: You buy 100 shares of TUTU for $50.

Put B exercised: You sell 100 shares of TUTU for $58.

As a result, you yield the $8 difference per share.

But don't forget: there was a -$3 per share net premium outflow incurred when opening the position.

Since the multiplier is 100, the total profit is ($58-$50-$3)*100*1=$500.

Note: The potential profit for this strategy is limited. Even if TUTU's stock price falls to $0, the maximum profit is still $500.

Maximum potential loss and profit for options are calculated based on the single leg or an entire multi-leg trade remaining intact until expiration with no option contracts being exercised or assigned. These figures do not account for a portion of a multi-leg strategy being changed or removed or the trader assuming a short or long position in the underlying stock at or before expiration. Therefore, it is possible to lose more than the theoretical max loss of a strategy.

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III. How to construct a bear put spread on Futubull

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IV. Applying the bear put spread strategy

1) Expect the underlying stock price to fall, but with limited downside

Investors often base their strategies on short-term price trends. If these trends change or fade quickly, the original spread strategy may become ineffective. Therefore, a bear put spread is generally better suited for short-term speculation rather than long-term investment.

If an investor expects the stock price to slightly drop within a certain time frame, they can buy put B and sell put A. This approach allows them to possibly benefit from a stock price decrease while limiting the initial cost.

2) Expect the underlying stock price to fall, already bought a put, and want to reduce costs

Expecting the stock price to fall, an investor may buy an at-the-money (ATM) put B. To help offset some of the high premium for put B, sell a put A with a lower strike price.

If an investor expects the underlying stock price to decrease, they can create a bear put spread by buying an ATM put B and selling an OTM put A at the indicated support level. This strategy allows them to potentially profit from the stock's decline while reducing the initial cost.

V. FAQs

Q: Choosing the strike price?

A:

Conservative: Relatively conservative investors may buy and sell both in-the-money puts. In this way, there is a higher probability the options will expire OTM, but this also causes a lower theoretical maximum profit.

Moderate: More moderate investors may sell an out-of-the-money put and buy an in-the-money put, taking on additional level of risk in exchange for potentially moderate returns. (For example, sell an OTM put A at the lower support level and buy an ITM put B close to the current stock price.)

Aggressive: More aggressive investors may buy and sell both out-of-the-money puts. Such a combination can generate higher returns potentially, but there's a lower probability the options will be in-the-money by expiration.

Q: How's a bear put spread working in different scenarios?

A:

Scenario 1: When the stock price is below put A strike price or is above put B strike price

Both options are either in-the-money (ITM) or out-of-the-money (OTM) simultaneously. This indicates that the strategy has reached the boundary of theoretical maximum loss or maximum profit.

In this case, investors can choose to hold the position until expiration. Whether suffering the loss or gaining the profit, Futu will automatically liquidate the options upon expiration. Futu will automatically liquidate the options upon expiration only in cases where the account meets margin requirements, and it is important to verify that this applies to your account. Liquidation is not guaranteed, and investors should monitor their positions closely.

Scenario 2: When put A strike price < stock price < put B strike price

Although Put A is out of the money, there is still a risk of early assignment. If this risk is high and you want to avoid holding the stock, consider these two methods:

Method 1: Buy to close the put A position and sell to close the put B position. Exit the bear put spread strategy by closing both options and realize the profit or loss.

Method 2: Buy to close the put A position. While this may be costly, it removes the risk of assignment and maintains the profit potential of put B should the underlying stock continue to fall. Some investors may choose to sell put B and keep short put A if they expect the stock price to stay above put A at expiration. However, despite the limited theoretical loss of a naked short put, it remains risky, and investors could incur significant losses.

Scenario 3: Turn a bear put spread into a long put butterfly

If investors have constructed a bear put spread, but the price of the underlying asset has already fallen to a support level, they may worry that the stock price will remain steady near this level by expiration, causing the options' time value to decline.

To help address this, investors may add a bull put spread below the bear put spread position, changing the strategy into a long put butterfly. This not only allows them to potentially capture the time value of the bull put spread, but also helps protect the unrealized gains from the bear put spread.

Scenario 4: Applying long diagonal bear put spread instead of bear put spread

The main difference between a long diagonal bear put spread and a regular bear put spread is the expiration date of the options. In a long diagonal bear put spread, you buy a long-term put option with a higher strike price and sell a short-term put option with a lower strike price, keeping the number of contracts the same.

Investors establish a long diagonal put spread to get greater net debit. If the short-term put expires out-of-the-money, investors can sell another put with the same expiration date as the long-term put, constructing a bear put spread. In this scenario, compared with the bear put spread above, the long diagonal put spread theoretically earned an extra premium on the short-term put.

However, note that if the stock price falls below the lower strike price before the closer expiration date, the sold short-term put position will suffer a paper loss in the meantime.

Q: What is the difference between a bear call spread and a bear put spread?

A: Both strategies aim to profit from a decline in stock price, but they differ in approach and risk management.

If investors are not bullish on the market outlook, and the current implied volatility is high, they may choose a bear call spread to potentially capture the downside profit while also limiting the potential losses.

If investors are bearish on the market outlook, and the current implied volatility is low, they may choose a bear put spread to potentially capture the downside profit while also reducing the overall premium paid.

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Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.

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