A bear put spread is a type of options trading strategy used when the trader expects the price of the underlying asset to decline. This strategy involves buying a put option and selling another put option with a lower strike price. The goal is to profit from the decline in the underlying asset price while limiting the amount of money that can be lost if the price of the underlying asset does not decline.
When might you use a bear put spread?
There are a few different scenarios where you might want to use a bear put spread.
If you’re bullish on the market in general but think a particular stock is overvalued, you could sell a puts on that stock. This will give you downside protection if the stock falls while still allowing you to participate in any gains in the broad market.
Another scenario where you might want to use a bear put spread is if you have a stock that you’re worried might fall in the short-term, but you still think it has long-term potential. In this case, you could buy a put to protect yourself against a short-term drop while still holding on to the stock for the long term.
How does a bear put spread work?
To create a bear put spread, you would buy one put option and sell another put option with the same expiration date but with a lower strike price. The difference between the two strike prices is known as the spread.
For example, let’s say you wanted to create a bear put spread on XYZ stock which is currently trading at $50 per share. You could buy a put option with a strike price of $55 and sell a put option with a strike price of $50. This would create a spread of $5.
If the stock falls below $50, the put you bought will become in the money, and you will be able to exercise it at $55 per share. However, because you also sold a put, you would be obligated to sell your shares at $50 even if the stock falls further. This is why the bear put spread is often used as a hedging strategy – it allows you to protect yourself against a short-term drop in the stock price while still allowing you to participate in any potential upside.
The benefits of using a bear put spread
There are a few key benefits to using a bear put spread:
- Limited downside risk – because you’ve sold a put, your potential losses are limited to the premium you paid for the options.
- You still participate in any gains in the underlying asset – if the stock price falls, you will be able to sell your shares at a higher price than the current market price.
- You don’t have to wait for the stock to fall before you start making money – unlike other strategies like short selling, you don’t have to wait for the stock price to fall before you start making money.
- It’s a relatively simple trade to execute and manage – compared to other strategies like short selling and a bear put spread much more straightforward to execute and manage.
When to use a bear put spread
A bear put spread can be used in several different scenarios, including:
- You’re bullish on the market but think a particular stock is overvalued
- You have a short-term losing position in a particular stock that you want to hedge against a further decline.
- You’re bullish on a particular stock but want to limit your potential losses if the stock price falls.
- You want to generate income from options premiums.
The bottom line
A bear put spread is a versatile options trading strategy used in several different scenarios. It allows you to profit from a short-term decline in the stock price while still participating in any upside potential. However, it’s essential to be aware of the risks associated with this strategy, including time decay and margin requirements. New traders and investors are advised to use an experienced and reliable online broker from Saxo Bank and trade on their demo account; sign up for a free trial here.