Bear Spread Option Strategy 101

This is a term used to describe a strategy that traders use when they expect the price of security to fall.

This article will explain the intricacies of them in laymen’s terms.

Simple bear spread-cessities

First, you need to know what an option is, as a bear spread is an option strategy.

An option is essentially a contract or agreement that gives the buyer a right to sell or buy an asset, such as a house, stock, or index, for a certain amount at a given time.

When a trader expects the price of this asset to fall, they use an option spread strategy in which they buy some options that have a lower strike price (the agreed price to sell) and some options with a higher strike price.

Vertical Bear Spreads

With vertical bear spreads, the spread can be entered with either a net credit or a net debit.

This is if the options bought cost more than those sold going into the spread.

Vertical Bear Call Spread

This type of spread is established with a net credit by using call options.

Sometimes it is called a Bear Credit Spread.

The above graph shows the profit potential of using a bear call spread.

In this case, the stock rising to $40 results in $300 loss for the trader, while a fall to $35 nets them $200.

Example of a bear call spread

Our company, John & Smiths Incorporated, trades at $37 in January.

Our trader decides that stock in this company will fall.

He decides to buy a March 40 call for $100 and conversely sells a March 35 call for $300.

A March 40 means he has a right to sell shares in that company at $40 each, regardless of the market price.

And the opposite goes for the option he sold: he has to sell the shares for $35, even if the market price changes.

Since he spent $100 but sold for $300, he has a net credit of $200 upon entering the trade.

The price drops to $34 by the date of expiration (March).

Both options expire, and the trader gains the $200 as profit.

However, let’s say the stock had rallied to $42.

The July 40 call bought would have $200 in value, and the July 35 call would have $700 in value.

The difference in strike prices gives us our net value of $500 for the spread as a whole.

Buying back the spread would mean a loss of $300 overall once we deduct the $200 credit he earned putting on the spread in the first place.

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Bear Put Spread

This is established for a net debit as opposed to net credit if put options are brought in.

Often called a vertical bear debit spread.

Example

Our company in this example is called Sunshine Saloons.

It trades at $38 on the stock market as of August.

An options trader comes along and is bearish on their stock, deciding to enter a bear put spread position.

He proceeds to buy a September 40 put for a total of $300, while selling a September 35 put for $100 simultaneously.

A net debit ensues of $200 as he spent more than he sold to partake in this exercise.

Sunshine Saloons becomes embroiled in an embezzlement scandal with a former director, and its stock drops to $34 by the time put options expire.

The puts will expire in a state of what investors call, in-the-money.

The September 40 he bought now has $600 in intrinsic value and the September 35 now has $100 in intrinsic value.

With a final net value of $500 for the spread, and taking into account the debit he accrued when he placed the trade ($200), he sees a healthy profit of $300.

This represents the maximum profit possible from the spread.

Had the stock rallied by the expiration, the options would expire worthlessly, and the loss would be the sum of the initial debit taken on the spread, of $200.

Horizontal & Diagonal Bear Spreads

This is a long-term put strategy. It involves the buying of long-term puts, with an equal number of short-term puts of the same stock.

This is used when a trader is bearish regarding the stock in the long term, but less so in the short term.

They have doubts about the stocks ability to stay strong for the long haul, but may be able to profit from the perceived likelihood of short-term gains.