Bear Put Spread: Definition, Example, How It's Used, and Risks
KEY TAKEAWAYS
- A bear put spread is it is intended for traders planning to profit on downward market movement with a reduced risk exposure.
- The strategy implies buying and selling puts on the same base crypto asset, with different strike prices and/or maturity periods.
- This spread builds a positon wich results in a net debit, as the premium paid for the purchased put option surpasses the premium received for the sold put.
- Examples and practical applications featuring Bitcoin as the underlying crypto asset will be provided in the article.
What Is a Bear Put Spread?
A bear put spread represents a strategy employed when an investor holds a bearish outlook on the base crypto asset. It is alternatively referred to as a bearish put spread.
The strategy involves the simultaneous purchase of one put and sale of another put with a lower exercise price on the identical crypto asset. Both puts have the same expiry date, which allows traders to reap benefits from the declining prices with a risk-mitigating strategy in place.
Outlook
Market Outlook
This strategy enables investors to reap financial gains from the anticipated downturn while effectively controlling their risk exposure. Therefore, the market participant needs to possess a bearish outlook on the market, anticipating a drop in the underlying crypto asset’s value.
When to Use the Bear Put Spread
Typically, the bear put spread option strategy is employed when a trader expects the base asset's price to fall moderately over a specific time frame. It is not ideal for situations where a massive price drop is expected, as the potential profit is limited by the sold put option.
Motivation
The chief purpose for employing a bear put spread strategy is to reap rewards from a downward market trajectory while concurrently curbing possible financial setbacks. This strategy is preferred by cautious investors seeking to seize opportunities arising from falling asset values with a risk-managed approach.
The Basics of a Bear Put Spread
Constructing a bear put spread involves purchasing the higher strike put and selling the lower strike put on the same base crypto asset. This spread results in a negative cash flow or a debit. The reason behind it is the premium paid for the purchased put being higher than the premium received for the sold put.
How to Set Up a Bear Put Debit Spread
When setting up a bear put debit spread, traders should carefully select the appropriate exercise prices and expiration dates to match their market outlook and risk tolerance. This involves a few key steps:
- Identify the underlying cryptocurrency, such as Bitcoin, and determine its current price.
- Select an appropriate expiry date for both put options.
- Purchase a put option with a exercise price above the current market price.
- Sell a put option with a lower exercise price, also with the same expiry date.
Entering a Bear Put Debit Spread
To initiate a bear put debit spread, the investor will follow the procedure outlined above. Upon purchasing one put option and selling another one, an investor establishes the spread. Prior to entering the position, one should make certain they have a thorough comprehension of the market outlook and an anticipation of a bearish price movement.
Exiting a Bear Put Debit Spread
To close a bear put debit spread, the trader can either sell the purchased put option and buy back the sold put option simultaneously, or wait for the options to expire and exercise the purchased put option if it is in-the-money.
Profit/Loss
The profit or loss potential of a bear put debit spread depends on various factors, such as the exercise prices, the net premium paid, and the price movement of the base crypto asset. Here is a breakdown of the key profit and loss components.
Break Even Point
The break-even point for a bear put debit spread is the point at which the trader neither gains nor loses money. It is calculated as follows:
Break Even Point = Strike Price of Purchased Put - Net Premium Paid
Max Gain
There is a certain limit to the maximum gain that a trader can receive with a bear put debit spread. It occurs when the base cryptocurrency's price is equal to the exercise price of the sold put option at expiration. The max gain is calculated as follows:
Max Gain = (Strike Price of Purchased Put - Strike Price of Sold Put) - Net Premium Paid
Max Loss
Risk-averse traders may find the bear put spread appealing as its maximum potential loss is limited. It is equal to the net premium paid for the spread. This loss occurs when the underlying crypto asset's price is equal to or above the exercise price of the purchased put option at expiration:
Max Loss = Net Premium Paid
Understanding the profit and loss potential of a bear put debit spread is crucial for traders to manage their risk exposure effectively and make informed decisions when implementing this strategy.
Risks
Investing in options strategies like the bear put debit spread comes with inherent risks that market participants must be aware of and prepared for.
Time Decay Impact
Time decay, also known as theta, is the erosion of an option's value as time passes. As the expiry date approaches, the time decay accelerates. Time decay can negatively impact the bear put debit spread if the base crypto asset's price doesn't move as anticipated, causing the purchased put option's value to decrease faster than the sold put option.
Implied Volatility Impact
Implied volatility represents the market's expectation of a crypto asset's price movement. When implied volatility increases, the value of options also tends to increase. If implied volatility decreases after initiating the bear put debit spread, it can negatively affect the overall profitability of the position.
Assignment Risk
Assignment risk occurs when the sold put option is exercised before expiry date, requiring the trader to buy the underlying cryptocurrency at the exercise price or settle in cash. Early assignment is rare but can happen, especially when the sold put option is deep in-the-money or close to its expiration date.
If the sold put option is exercised, the trader will be obligated to buy the base crypto asset at the exercise price, which may be higher than the current market price, resulting in a loss. However, since the trader also owns a long put option with a higher exercise price as part of the bear put debit spread, they can exercise that option to sell the cryptocurrency and offset their loss from the assigned short put position.
Expiration Risk
Expiration risk for a bear put debit spread arises when the trader doesn't close the position before expiration. If both options are in-the-money, they may be automatically exercised, causing the trader to sell and buy the base crypto asset at the respective exercise prices. If one option is out-of-the-money, it will expire worthless. It's essential to be aware of your broker's exercise and assignment policies to avoid unexpected outcomes at expiration.
Adjusting and Hedging a Bear Put Debit Spread
Adjusting a Bear Put Debit Spread
Traders can adjust a bear put debit spread by rolling it to a different strike price or expiration date. This can be done to better align the strategy with the trader's revised outlook on the underlying crypto asset or to reduce the overall risk exposure.
Rolling a Bear Put Debit Spread
Rolling a bear put debit spread involves closing the current spread and simultaneously opening a new spread with different exercise prices and/or expiry dates. This can help the trader manage their risk and potentially increase the profitability of the strategy.
Hedging a Bear Put Debit Spread
Traders can hedge a bear put debit spread by taking an opposite position in the base cryptocurrency or another related instrument. This also can help mitigate potential losses if the base crypto asset's price moves contrary to the trader's expectations.
Example of Bear Put Spread
Let’s take a look at the bearish put spread example. Assume Bitcoin is currently trading at $20,000. A market participant expects a moderate decline in price over the next month. They decide to implement a bear put debit spread by taking the following actions:
- Purchase a put option with a strike price of $19,500 and an expiration date one month from now, for a premium of $500.
- Sell a put option with a exercise price of $18,000 and the same expiry date, for a premium of $200.
The net premium paid for this spread is $300 ($500 - $200). Now, let's analyze the profit/loss potential for this example.
Break Even Point = Strike Price of Purchased Put - Net Premium Paid.
Break Even Point = $19,500 - $300 = $19,200.
Max Gain = (Strike Price of Purchased Put - Strike Price of Sold Put) - Net Premium Paid.
Max Gain = ($19,500 - $18,000) - $300 = $1,200.
Max Loss = Net Premium Paid Max Loss = $300
In this example, the trader reaches break even if the Bitcoin’s value stands at $19,200 upon expiry. They will realize the maximum profit of $1,200 if the price plunges to or below $18,000. The maximum loss of $300 takes place if the price of Bitcoin stays at or above $19,500 when the contract expires.
FAQs
How Do You Close a Bear Put Debit Spread?
A bear put debit spread can be closed by simultaneously selling the purchased put option and buying back the sold put contract before expiration. Alternatively, the trader can wait for the options to expire and exercise the purchased put option if it is in-the-money.
What Is a Bear Put Debit Spread?
A bear put debit spread is a bearish options strategy involving the purchase of a put with a higher strike price and the sale of another put with a lower exercise price on the same base crypto asset. As a result, you will have a net debit.
Can I Close a Bear Put Debit Spread Early?
Yes, a bear put debit spread can be closed early by simultaneously selling the purchased put and buying back the sold put. Closing the position early can help the trader lock in gains or minimize losses if the underlying crypto asset's price moves contrary to their expectations.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
