Purchasing a high strike price put and then selling a put with a lower strike price
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In a bear put spread, the basic idea is to purchase a high strike price put and then sell a lower one. The goal is a decline in stock price, with a close – at the time of expiration – that is equal to or below the lower strike price.
The spread is vertical, with two strike prices that expire in the same period. The put option that is sold – the one with the lower strike price – is clearly worth less than the put option with the higher strike price that is purchased. This results in a net debit, as the money received for selling the lower strike price put is less than the money paid for the higher strike price put.
There are two basic options contracts: puts and calls. Puts allow traders to sell an option’s underlying asset at a designated strike price up until the option expires; calls allow the trader to buy the asset at the designated price up until the option expires.
The general strategy of a bear put spread is to buy a higher strike price put and then sell a lower one; the goal is to watch the stock decline and close at any point that is equal to or above the lower strike price at the time of expiration.
If the stock closes at or below the lower strike price, the trader profits the difference between the strike prices, minus the premium initially paid.
To better understand a bear put spread, a basic understanding of options is necessary. There are two option types: calls and puts. A call enables an owner to purchase an option’s underlying asset at the contracted strike price, up until the date that the call option expires.
A put option, on the other hand, allows the owner to sell the option’s underlying asset at the strike price outlined in the contract, up until the date that the put option expires.
Profit and Loss in a Bear Put Spread
As mentioned above, the result of a bear put spread is a net debit. The maximum amount that a trader loses on any debit spread – such as the bear put spread – is the amount that the trader paid for it, otherwise known as the net debit. It is the price of the higher strike price option minus the price of the lower strike price option. It happens if, at the time of expiration, the underlying asset closes at any price that is higher than the strike price of the purchased put option.
With minimal risk comes minimal reward. The most that a trader can profit from a bear put spread is the total difference between the strike prices, after deducting the amount paid for the higher strike put. The maximum gain occurs if the underlying asset closes at any price equal to or below the lower strike price at the time of expiration.
In such a case, the trader exercises his higher strike put, selling the stock at the higher strike price. If it’s in the money, the other, lower strike price put option is exercised automatically, and the trader purchases the stock at the lower strike price. Thus, no net position in the underlying stock is created.
If at expiration, the stock price is at or above the higher strike price, then both options expire unexercised. If the stock price is below the strike price of the higher strike option but not below the strike price of the lower strike option, then the higher strike put is exercised, giving the trader a short position in the underlying stock.
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