Hey everyone. This is Kirk, here again at optionalpha.com. And in this video tutorial, we're going to
talk about a bear put spread, one of the favorite strategies of some traders when they get started
here once they learn how spreads work. Let’s get right into it here as always. We're going to talk about the market outlook
first for a bear put spread. It's really employed when the trader thinks
that the underlying price of the stock is going to go down moderately in the near term. And I say moderately because what you’re
basically doing with a bear put spread is you’re shorting an out of the money put
which is going to reduce the cost of your bearish position. It’s going to reduce the cost of the trade,
but it’s also going to cap your profits. This is different than if you’re going to
just outright buy a long put option in which case, you think there’s going to be a significant
move down in the underlying stock. But here, you think there’s going to be
a moderate move down and you’re going to forego some of that large profit potential
for a lower-cost strategy overall. How you set this up is very easy. You’re going to buy a higher striking in
the money put option and then you're going to sell a lower striking out of the money
put option with the same underlying security and the same expiration date. In this example, we’re going to buy one
in the money put, in this case, it’s going to be a 40 strike put, and then we’re going
to sell one out of the money put to help pay for some of the cost of buying that one put
option. You want to make sure that you make these
spreads even whenever possible, so you want to sell and buy an even number of contracts. Now, this is different than back spreads,
in which case, you’re going to add some extra contract. Just check out one of those videos on put
back spreads or call back spreads to understand what I’m talking about. What’s the risk? The maximum loss on these strategies is limited,
so that’s the good thing. The worst that can happen is that at expiration,
the stock is higher or above the long put strike price, in which case, both options
expire worthless and you simply lose the money that you outlaid in the beginning. Whatever the net debit or net cost of this
trade was, that’s your maximum loss only if the stock closes higher than your long
put strike price. Since this is a moderately bearish strategy,
anything where the market is rallying and is going to be bullish is going to create
a loss on this strategy. The profit potential is also limited like
we talked about earlier. The best that can happen is that the stock
closes anywhere below your short strike price and that's going to be at 35. In this case, you’d take in the full profit
potential, but you are limited in your upside gains because you sold that option to help
fund the purchase of the 40 strike put. Volatility for this particular strategy is
going to be a little bit non-important or a non-factor overall. Since you’re long an option and short an
option, volatility is more or less going to offset each other to a large degree. Volatility is something that you don’t really
have to consider. It is going to make a big change as you start
to get further out in your out of the money options. As they get more out of the money, they’re
going to be more susceptible to big changes in volatility, but for the most part, it’s
not going to make that big of a difference if you keep your strike prices close. The same thing with time decay in regards
to this strategy, this put spread. Time decay is actually going to have a pretty
low impact on the overall position. Since you’re long one option and short,
the overall effects are going to offset each other. Calculating the breakeven strategy on this
particular profit loss diagram is actually fairly easy. What you’re going to do is you’re going
to take the long put strike price which is down here at 40 and you’re going to subtract
the debit that it cost you to enter this particular strategy. You’re going to take a 40 and minus the
$300 or $3 per contract and that gets you a 37 which is where this strategy breaks even. You want to see the stock move at least down
to 37 and then you’re going to have a net breakeven point on the strategy overall. Anything below that point and you start to
make a profit. Let’s take a look at a quick example here
as we’re just talking about it. Say the stock price is at $37, so right here
in our breakeven point. If you buy one 40 strike put, it’s going
to cost you just that one option $400. What you’re going to do is you’re going
to sell one 35 strike put for $100 and help fund the purchase of this long put. The net debit is still $300. You outlaid 400 and you took in a credit of
100, so that net debit is still $300 which you give up to the market for the right to
own this strategy. Your max loss is the $300. That's your strike price at 40 minus the credit. Your strike price at 40 here minus the $300
debit and that's going to create that $37 breakeven period, but your max loss is going
to be the $300 in which you outlaid money for the strategy. The maximum profit is what's left here. It's only the difference between your short
strike at 35 and your breakeven point which is only $2 per contract or $200 credit. If the strategy or if the underlying stock
trades anywhere below 35 by expiration, then your maximum profit is $200 on this position. Some tips and tricks with this bear put spread. The strategy is really a basic building block
for more complex strategies. Like the put back spreads and call back spreads,
this is something that you really need to understand and master, how just two options
can create different types of profit loss diagrams. Remember, purchasing spreads that are slightly
out of the money are best. That way, you don’t pay the high intrinsic
value for the options. If the stock is trading at 37, you could even
move the strikes out to 35 and 30 and purchasing those options that are slightly out of the
money. Hedging can be a very easily achieved by purchasing
an additional call option above 40 for short-term volatility moves. You can see on this strategy we're very exposed
to higher prices that leads to a loss. If we do anticipate short-term moves higher
in the stock, but we still overall feel bearish, then what we can do is we can add one call
option here at 40 and create more of a backspread. And that's going to be covered in other videos
in our tutorial series as well. But that’s a really easy way to hedge your
position against any moves in volatility or higher strike prices. As always, I hope you guys enjoy this video,
and thanks for watching. Please take just one second here and share
this video with any of your friends, family or colleagues on your favorite social network.
