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Bear Put Spread Option Strategy

When the market is volatile and you are moderately bearish on it, you can minimize your cash invested in a position, and minimize your risk while still reaping high profit potential by utilizing a Bear Put Spread. This strategy involves buying a put option at one strike price and selling a put on the same asset at a lower strike price. Usually both options will have the same expiration date.

Your cost in establishing this position is less than it would be in just buying a put option, because you are also selling a put at a lower strike price. So you are taking in some money from that sale which reduces your cost outlay and raises your ultimate return-on-investment.

With this strategy, your potential loss is limited to the premium you paid for the puts less commissions and the premium you collected for the puts you sold. Unlike the outright purchase of a put option, your potential profits are limited to the difference between the strike prices multiplied by 100 times the point value of the contract, less the cost of establishing the position. An option calculator such as Option-Aid performs these calculations for you instantaneously.

When we initiate a Bear Put Spread, the put that we purchase is normally at-the-money. We generally allow enough time for the market to make the anticipated move. The put we sell has the same expiration date, with a lower strike price (at a price point that we feel the asset can easily move to within the time period until expiration, yet not too low because it lowers the premium we are collecting to reduce our cost basis).

It is important to discuss an additional benefit of doing a Bear Put Spread instead of buying just a put option when the issue you are considering has high volatility. If you purchase a put option on an asset that has high volatility, the asset price could go down, as you expected, yet at the same time, the option price could drop if the implied volatility of the asset declines significantly during that time. So although you were right about the directional movement of the asset, you would have lost money in a straight put option play. A Bear Put Spread could ameliorate that risk, because it is the spread between the put option prices that determines your profit. The put that you sold would also go down in value as volatility declined, but the spread between the put prices would increase as the price of the underlying asset decreased. That would give you a profit instead of a loss.

It is also important to cover risks and caveats of this strategy.

The risk of this position is limited and known as described above. Remember that the commission you pay for this position will be higher than the commission for a straight option play, because you are initiating two related option transactions.

When you initiate a Bear Put Spread rather than outright purchase of a put, you are limiting your upside potential. If the asset price falls like a rock, then you aren't able to fully participate in that movement because the lower strike price put that you sold will probably be exercised, limiting your gain.

The major benefits of this strategy occur when volatility is high, making the purchase of puts expensive and increasing the risk of a drop in volatility.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.




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