Bear Put Spreads

Bear Puts spreads are a popular way to option spread. Similar in design to Bull Call spreads, Bear Put spreads involve two option choices. This spread allows for limited risk, limited reward and a cost basis that is typically much lower than buying options outright. Bear put spread traders typically want the market to decline before option expiration.

To establish a Bear Put position buy a put of a higher strike and sell short a put of a lower strike. Normally the buy is close to the underlying price. Buying close to the underlying price drops your entry cost substantially when compared to a straight option purchase. You can buy further out of the month sprads to lower trade costs even more.

Example
Mar '05 Sugar futures	8.13
Mar '05 Sugar 8.00 put	59 points
Mar '05 Sugar 7.50 put	37 points

Buy the 8.00 put and sell short the 7.50 put to establish the Bear Put spread.

Long Mar '05 Sugar 8.00 puts	59 points	$660.80
Short Mar '05 Sugar 7.50 puts	37 points	$414.40
Net Cost:	22 points	$246.40

The position cannot lose more than the initial cost plus trade fees and the maximum upside is the difference between the two strike prices minus trade fees.

Maximum profit =	differences between the two strike prices minus trade fees
Maximum profit =	(8.00 - 7.50) - trade fees
Maximum profit =	50 points - trade fees
Maximum profit =	$560 - $70
(Assume $35 per option for all trade fees and commissions. Sugar is $11.20 per point.)
Maximum profit =	$490

Breakeven analysis
Bear Put spreads provide a more favorable risk reward than buying an option alone. Your breakeven point is where the market moves beyond the time value on the option. Time value is option premium minus intrinsic value.

In our March Sugar example the 8.00 puts are out of the money, therefore the entire option premium is time value. In order to re-coup the cost of the option the market needs to move below 7.41. (Option strike minus time value)

Buying a put alone

Breakeven Analysis	(strike price - time value) - trade fees
Breakeven Analysis	(8.00 - 0.59) - trade fees
Breakeven Analysis	7.41 - 3 points
(Assume 3 points per option for all trade fees and commissions)
Breakeven Analysis	7.38

The breakeven for a Bear Put spread is calculated the same way. In our example the cost of the spread is 22 points.

Bear Put spread

Breakeven Analysis	(strike price of purchased put - time value) - trade fees
Breakeven Analysis	(8.00 - 0.22) - trade fees
Breakeven Analysis	7.78 - 6 points
(Assume 3 points per option for all trade fees and commissions)
Breakeven Analysis	7.72

Risk profile
The risk for Bear Put Spreads is the amount of premium paid for the spread plus all trade fees associated with the trade. All of your investment is at risk until the market declines below the strike price of the long option in your spread. At exercise if the market is trading above the long option strike price then your spread is worthless and you loose 100% of your investment. A 8.00 / 7.50 Sugar Bear Put spread is worthless on expiration day if the price of Sugar is above 8.00. Below the strike price the long option the spread makes 100% of the move of the underlying issue at expiration until the short option's strike price. For instance a 8.00 / 7.50 Sugar Bear Put spread makes money at expiration below 8.00 until the market reaches 7.50. Profits are limited to the short option's strike price. A Sugar 8.00 / 7.50 Bear Put spread is worth 30 points on expiration if the market is trading at 7.70. The same spread will be worth 50 points at 7.50, and for all values below 7.50 on expiration day.

Maximum Risk =	Cost of Initial Trade plus commission and trade fees
Maximum Risk =	$246.40 + $140
(Assume $35 per option for all trade fees and commissions. Sugar is $11.20 per point.)
Maximum Risk =	$386.40

Risk of Exercise
If a purchased put option is in the money (the market price is below the strike price) then your option can be automatically exercised by the exchange. At exercise the option holder will receive a short futures contract at the strike price of your option. A March 230 Corn put would exercise into a short March Corn future at 230 if the price of March Corn is below 230 on expiration day. One important note, when your option is exercised you will need to have sufficient funds in your account for the margin requirement.

In the case of Bear Put spreads it is possible to for the market to be below the price of the purchased put but above the short option at exercise. In our Sugar example, assume that at expiration Sugar futures are trading at 7.70. The long put option at 8.00 would be exercised into a short futures contract at 8.00 giving you a profit of 30 points. The short put option at 7.50 would expire worthless. You would be left with a short Sugar futures position from 8.00.

Assume at expiration Sugar futures are trading at 7.20 - well below the lower strike price of the Bear Put spread. The long put option at 8.00 would be exercised into a short futures contract at 8.00. The short put option at 7.50 would be exercised into a long futures position at 7.50. The short futures at 8.00 would offset against a long futures contract at 7.50 resulting in a 50 point profit - minus any trade fees.

Option Values Before Expiration
At expiration options are worth 100% of intrinsic value. Prior to expiration options can be worth more or less than their intrinsic value. Various market forces act on option prices prior to option expiration. Some of these forces are time before expiration, market volatility and interest rates. For example an important government report could cause a market to drop tremendously. Put option values for this market could jump considerably in response to the news announcement.

Uses for Bear Put Spreads
A Bear Put spreads are useful in any market, stock or futures. Since entry costs are typically less with Bear Put spreads than with straight option purcahses, you could use the Bear Put spread to establish a larger position in a market. If the market moves in your direction you can exit the Bull Put spread with a profit and roll to higher strike prices. In the Sugar example, if the market moves to 7.50 you could exit the 8.00/7.50 spread and establish a new position at 7.50/8.00 or even 7.00/6.50.