This year started with a Bull market that gave an 11% gain from January to the beginning of April. Then April was a bit choppy with a close of about the same as it started. So far May has shown an 8% drop.
If you are strictly a stock investor, your investment strategy has now turned to shorting stocks. Of course, when shorting a stock you have to deal with the disadvantage of a short position - unlimited risk. However, if you trade options, you will find that there are several strategies which will profit from a declining stock price but have a defined maximum risk.
A Bear Put Spread is one of those option strategies that will give you a defined maximum risk in return for a defined maximum gain.
What is a Bear Put Spread?
When a Put is traded, there is a potential gain that is in direct proportion to the drop in value of the underlying stock. However, the potential loss could be the entire premium that was paid for the Put. A Bear Put Spread is a refinement of the standard purchase of a Put. It will decrease the amount of premium that is at risk.
With a Bear Put Spread, the amount of the potential loss is decreased but the tradeoff is that the potential gain will be limited. It is constructed by buying a Put which will profit from a decline in the underlying stock and, at the same time, selling a Put with the same expiration date but with a lower strike price. The short Put will offset some of the cost of the long Put. This trade will require a net cash outlay (a debit trade) since the amount received from the sale of the Put will be less than the amount paid for the long Put.
The typical Bear Put Spread is created when you buy in-the-money Puts and sell out-of the-money Puts.
As an example, I am analyzing Cognizant Technology Solutions (CTSH - Analyst Report), which is trading at $59.63. If my analysis indicates that the stock could continue to drop but is not likely to drop lower than $55, I can open a Bear Put Spread by buying the $60 Jun Put for $2.75 and selling the $55 Jun Put for $0.95, giving a net cost of $1.80 per share. The calculations for one contract are:
Buy Jun $60 Put: -$275.00
Sell Jun $55 Put: +$95.00
Net Cost: $180.00
The $60 Put is bought because I believe the stock will continue to go down. The $55 Put is sold because I think the stock will not go below this price. So, for each contract, the cost is $180 instead of the $275 that would have been paid for only the long Put.
To make the optimum trade using a Bear Put Spread, a trader will estimate how low the stock price might go and decide how long it might take to drop to that price. In the above example, if I expected the CTSH to drop significantly lower than $55, I could sell a lower priced Put. But, at some point the lower premium that is received will make the credit from the sale of the option unprofitable. If I expected a significant drop in the stock's price (further than $55), a better strategy would be to trade only the long option.
The gain on a Bear Put Spread is defined by the strike prices that were selected. The maximum gain occurs when the stock price is at, or lower than, the short Put position - in this example $55. The maximum profit is calculated by the differences between the two strike prices less the premium and costs of initiating the trade. In the example this would be calculated as $60 minus $55, and then less the net premium of $1.80 for a total of $3.20 or $320 per contract.
This calculation assumes that the option position is eventually closed. One could, of course, exercise the long Put and be assigned the short Put, thus buying stock at a lower price and selling it at a higher price. However, it is usually best to just close the option positions.
The maximum loss is limited. It occurs when the stock price is above the long Put at expiration in this example $60. In this case, both options decay to $0.00 and expire worthless. This means a loss of $180 for a single contract.
Of course, this assumes that there were no adjustments made to the trade after it was initiated. A savvy investor would not allow a losing trade to go to expiration. At some point between when the trade was initiated and the expiration, the trade could be closed out with a loss of less than the potential loss of $180 per contract.
Additional Factors to Consider
Take special precautions if the position is held until expiration date. If the underlying stock is close to the strike price, it is not known for sure if the short position will be assigned until the following Monday. So, either close out the trade early or be prepared for having the assignment occur or not occur on Monday.
Early assignment is possible, but generally only when the options are deeply in the money. Even though there is a long position to cover the short position, if an assignment occurs there will be a necessity of financing the long position for one day. An ex-dividend date or other type of special event could upset expectations for profits. It is usually a good strategy to avoid most option strategies when the expiration goes beyond an ex-dividend date.
The effects of decay with a short position and a long position may offset each other. However, it will not totally offset the decay and the passage of time will affect the profitability to some extent, especially in the last week before expiration.
The use of a Bear Put Spread can be profitable when you expect a stock price to decline in the short term, but not to a great extent. This strategy involves buying a Put. But, because the stock is not expected to drop a great amount, the cost of the trade is lowered by selling a Put at a lower strike price. The tradeoff for having a lower amount at risk will be a reduction in the maximum profit.
A close evaluation of the placement of the two different strike prices will show a significant difference in the potential return and risk of a Bear Put Spread.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.