A bear put spread is a debit spread created by purchasing higher strike puts and selling lower strike puts with the same expiration dates. This strategy is best implemented in a moderately bearish market. It provides high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required to buy the stock shares. The strategy has both limited profit potential and limited downside risk.
Steps to Using a Bear Put Spread
1. Look for a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock-not a large move.
2. Check to see if this stock has options.
3. Review put options premiums per expiration dates and strike prices.
4. Investigate implied volatility values to see if the options are overpriced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume charts over the last year.
6. Choose higher strike puts to buy and lower strike puts to sell with the same expiration date.
7. Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid.
8. Calculate the maximum potential risk by computing the net debit of the two option premiums.
9. Calculate the breakeven by subtracting the net debit from the higher strike price.
10. Create a risk profile for the trade to graphically determine the trade’s feasibility.
11. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
12. Contact your broker to buy and sell the chosen put options.
13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock rises to or above breakeven point.
14. To exit the trade, you need to sell the higher strike puts and buy the lower strike puts or simply let the options expire. The maximum profit occurs when the price of the underlying stock falls below the short put strike price. If and when the short put is exercised by the assigned option holder, you can exercise the long put to sell the shares purchased from the option holder at the higher long put price, pocketing the difference plus the premium of the short put.
Todd Mitchell is the CEO & Founder of Trading Concepts, Inc. He's been trading since 1994 and has mentored over 12,000 traders from Wall Street to Main Street. He's an expert at developing strategies for creating more consistent daily, weekly and monthly income.
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