Order Entry: Net Debit
Ideal Environment: Low IV
Profit Target: 50%
Definition: A bearish put spread consists of simultaneously buying an ITM put while selling an OTM put. The net premium paid is the result of buying the more expensive ITM put and selling the less expensive OTM put. The trade results in a bearish debit position. When entering the trade, the max profit and max loss are known.
Sell 1 OTM Put
Buy 1 ITM Put
When the stock price falls below the strike price of the short put at the expiration date. Both of the options in the spread will be ITM. The long put will have more intrinsic value than the short put. Max profit is achieved when the underlying stock price is below the short put strike price.
Max Profit= Distance between Put Strikes - Premium Paid (Debit) - Commissions
To calculate the breakeven stock price for the trade, use the following formula:
Breakeven Stock Price = Long Put (Strike Price) – Premium Paid (Debit)
If the stock price rises above the long put strike price at the expiration date, the trade undergoes a max loss.
Max Loss = Premium Paid (Debit) + Commissions
Suppose stock ABC is trading at $19 in April. An options trader bearish on ABC decides to enter a bear put spread position by buying a MAY 20 put for $220 and sell a MAY 18 put for $125 at the same time, resulting in a net debit of $95 for entering this position.
The price of ABC stock subsequently drops to $16 at expiration. Both puts expire in-the-money with the MAY 20 put bought having $400 in intrinsic value and the MAY 18 put sold having $200 in intrinsic value. The spread would then have a net value of $200 (the difference in strike price). Deducting the debit taken when he placed the trade, his net profit is $105. This is also his maximum possible profit.
If the stock had rallied to $23 instead, both options expire worthless, and the options trader loses the entire debit of $95 taken to enter the trade. This is also the maximum possible loss.
When to use a bearish put spread strategy?
At Tradezy, we recommend to use this strategy for stocks with a low implied volatility. The trader should have a short to intermediate bearish thesis. We look to buy the spread position that has around 45 DTE with a 50% probability of profit. The goal is to sell this spread back for 50% of max profit.