Bearish Put Spread (Option Strategy) Explained

Bearish Put Spread

Definition: A bearish put spread consists of simultaneously buying a put with more moneyness (higher strike price) while selling a put further out of the money (lower strike price). The net premium paid is the result of buying the more expensive put and selling the less expensive put. The trade results in a bearish debit position. When entering the trade, the max profit and max loss are known.

Setup:

1. Sell 1 put (lower strike) and buy 1 put (higher strike) with the same expiration dates

Risk: Defined. Since you own both a long and short put with the same expiration your max profit and loss are set at the entry of the trade.

Order Entry: Net Debit. You are buying a put with a higher strike which would have a higher premium due to it having more moneyness. The put you are selling has a lower strike price and would collect a lower premium. You are left paying the difference between the two put premiums to buy the spread for a net debit.

Direction: Bearish. You want the stock to either stay relatively flat or go down.

Ideal Environment: Low IV. Since you are selling the option, you want to sell in an environment where options are less expensive relative to their historical pricing and volatility.

Profit Target: 50%. This is the target we use at Mainstreetwolf (MSW) to lock in gains to keep our emotions out of it and be more efficient with using our capital.

Scenario Analysis

So now that we have established from a technical definition and setup viewpoint what a bear put spread is, let’s discuss the scenarios that can play out in a real-life situation.

For example, we have stock SPY that trades at $405. And we want to lean a little short delta while also benefiting from theta decay. We end up selling the $413 strike put and buying the $416 strike put both with the expiration of 46 days till expiration. We do this paying a total of $200 for the spread. How can buying this bear put spread play out?

All scenarios assuming 0 commissions and kept to expiration to make explanations simpler to understand.

Max Profit

The market falls as you have predicted, and the stock ends up at $395. When the stock price is below the strike price of the short put at the expiration date. Both of the options in the spread will be ITM. The long put will have more intrinsic value than the short put (therefore the spread is worth the difference is strike prices). Max profit is achieved when the underlying stock price is below the short put strike price.

Max Profit= Distance between Put Strikes – Premium Paid (Debit)

$100 = (($416-$413) x 100 shares) – $200

Essentially if the stock trades below the put you had sold, then you will be making money in the trade as time goes by.

Profit

Let’s say the market keeps pushing higher from when you bought the spread and the stock ends up at $413.50 at expiration. The $413 put you sold is out of the money and wouldn’t be exercised (why sell at $413 when you can sell at $413.50 😊). The $416 put you bought though has some value as it is ITM and would be worth $2.50 at expiration. So, it is really the amount you paid for the long put minus the premium paid for the spread.

Profit= Long Put Value – Short Put Value – Premium Paid

$50 = (($416-$413.50) x 100 shares) – $0 – $200

Breakeven Point

To calculate the breakeven stock price for this trade, we use the following formula:

Breakeven Stock Price = Long Put (Strike Price) – Premium Paid (divided by 100 shares)

$414 = $416 – $2

This is useful to understand where you will need to stock to be below to squeeze any profit out of the trade.

Loss

Let’s say the market continues to rip higher and blow past your breakeven point and ends up at $415.

Loss = Long Put Value – Short Put Value – Premium Paid

-$100 = $100 – $0 – $200

At least you didn’t have a full loser!

Max Loss

The fed just announced infinite QE and the markets rally and SPY ends at $420. This spread is going to be toast. If the stock price rises above the long put strike price at the expiration date, the trade undergoes a max loss.

Max Loss = Premium Paid (Debit)

-$200 = -$200

Neither of the puts would have any value and essentially you are out the premium you paid for the spread. The good news is that the trade is defined risk and you can’t lose more than you paid for the spread!

You don’t have to hold on to the trade till expiration

In all the above situations we talked about holding on till the expiration of the bear put spread. You don’t have to do that in the real world. You can sell the spread earlier for a profit or loss if you want. That can be 10 minutes into the trade or 15 days.

When to use a bearish put spread strategy?

At Mainstreetwolf, we use this strategy for stocks with a low implied volatility. The trader should have a short to intermediate bearish thesis. We look to buy the spread position that has around 30 – 60 DTE with a 68% probability of profit. The goal is to sell this spread back for 50% of max profit.

Trade Criteria

At Mainstreetwolf, we use this strategy when we want to be capital efficient while also wanting to be directional in a low implied volatility environment.

I want a stock that has at least under 5 Implied Volatility Rank (IVR) and has an RSI close to or over 70 as this is a bearish play.

The trader should have a short to intermediate bearish thesis. We look to sell a -70 delta OTM put against a long OTM Put and pay around 2/3 the width of the strikes with 30-60 DTE and close at 50% profit. Our goal with bearish put spreads is to make money on direction and an increase in implied volatility.

If you want to follow Mainstreetwolf’s real-time trades click the link: https://www.patreon.com/join/mainstreetwolf/checkout?rid=6794640