Bear Put Spread How to Video

Bear Put Spread (aka Long Put Spread)

Hello, my name is Brian Overby. I am the Senior Options Analyst at TradeKing, and author of The Options Playbook. Today we’d like to highlight one of the plays contained within The Options Playbook, bear put spreads, also known as bear vertical spreads, and more commonly as long put spreads. The convention in the Options Playbook is to call it a long put spread so we’re going to go with that, but what is a long put spread?

In order to describe it in detail, I think it’s really good to compare a long put spread as an alternative to buying a put outright. If I was bearish on an underlying, I actually thought the underlying stock was going to go down, one of the alternatives that we can do is actually go out and sell the stock short, if we just have access to the stock. But that can create a lot of headaches.

If I’m selling stock short, first of all the concept, for those that might not know, is that I’m going to actually borrow the shares from someone else that owns that stock at the brokerage firm, so the shares have to be able to borrow. Then I’m going to go out and sell those shares on the open marketplace. They’re not my shares, so I’m going to have to return them. The concept is that once I sell them, I hope the market on that underlying goes down and I can actually buy it back at a lower price, hence, making a profit on that trade.

Now, a great way to not deal with all the headaches of borrowing stock and selling it and buying it back is to pursue a put option outright. A put option is the right to sell stock at a specified price over a specific period of time. So if I do that, if I have that right to sell stock, I’m obviously bearish on the underlying market so buying a put is one way to participate. And hopefully I can just buy that put, and if my forecast is correct and it goes down, I can sell that put and hopefully the value of the put will be worth more than when I purchased it. Now if you buy the put, you have to realize that your risk here is all the capital that you pay for that put option. The premium paid for the put is the maximum risk of the trade, plus any commissions that might happen.

If I’m looking at buying a put, let’s talk about an example here and let’s get into our long put spread. Say the stock is trading at 100 and we’re thinking about buying a 100 strike put. We have to pick an expiration date so we’re going to go out a month in time, just to keep things simple. Your expiration will depend on your forecast. If you’re a long-term bear on this underlying stock you might want to go out as much as nine months, even out to a year and a half in time. There are a lot of option expirations that will go out that far. If I’m shorter term bearish I might want to pick a shorter term option, and in our example we’re going to do that, we’re going to use the one-month option contract.

Now if I buy that at-the-money option, a lot of people might think that’s fairly expensive, that’s it’s a costly option contract to buy, so a great alternative to that is to actually sell it on put strike. So we might buy the 100 strike put, and at the same time we’re going to sell the 95 strike put. So if we look at the rights and obligations of doing a long put spread, if we buy a put we receive that right, and in our instance we’re buying the 100 strike put. That means we’re going to have the right to sell stock at 100. Now on the other end, at the same time, we’re selling an option contract, but that strike is below the current price of 100. So we sell the 95 put, and guess what that does, that brings on an obligation, so we have a right to sell and an obligation to buy. So in this instance, if we go out and we do the long put spread, that sale of the second option actually lowers the cost of buying the put outright.

But now let’s talk about the good news and the bad news. That is the good news scenario, in that we have a lower cost in buying the put outright. But the bad news is we have limited and known upside potential on this trade–(audio skips again)–is correct. Why? Well if the underlying stock goes down and it goes below 95, we have the right to sell it at 100. If it goes all the way down, let’s say it goes to 80, what will happen is that obligation will kick in and somebody will take the stock at 80 and put to us at 95. So here our maximum upside potential is the difference between the strikes, which is 5 points in this instance, from 100 to 95, minus that net debit that was paid for that trade.

Now, just like I mentioned when we bought that put option, the net debit was the maximum risk of the trade from buying that put option outright. When you do a long put spread that is also the maximum risk. That risk obviously will be a little bit less than buying that put outright, but it’s also important to note that we will have increased commissions because we actually have two legs, and there might be complex tax treatments so you might want to check with your tax advisor before doing the bid.

But overall, another good news scenario about buying a long put spread is that as far as time value is concerned whenever you look at buying options, options are a decaying asset. As time goes by, the time value of the option is like an ice cube melting in the sun, it keeps evaporating each day that goes by and that underlying stock doesn’t move. So, with a long put spread we’re buying one option and selling it, so if time decay is hurting the one that we bought, it’s actually helping the one that we sold. So overall, it helps battle the effects of time decay over the life of the strategy.

My name is Brian Overby. I am the Senior Options Analyst at TradeKing, and author of The Options Playbook. If you’d like to learn more about investing, please check out our education center on tradeking.com, the companion website for my book, optionsplaybook.com, and our Trader Network, where investors connect to share ideas and strategies for trading stocks, options and more.