Bear Put Spread Navigating Bearish Markets to Limit Losses

Spreads versus naked positions

In the previous five chapters we looked into many multi-legged bullish strategies that offer different levels of bullishness from short-term to long-term. Experienced option traders prefer initiating spreads rather than taking on naked options, despite the fact that it may trim down the overall gains. The reason for this is because spreads make it easy to control risk as you know what your maximum possible loss could be. Risk visibility is more important than maximum profits, so better to settle for a small gain while having certainty of your losses.

A noteworthy element of spreads is the financing required, usually the purchase of one option is backed by the sale of another. This distinguishes a spread from an unconcealed directional position. In upcoming chapters we will cover strategies for moderately or strongly bearish outlooks. These approaches will be comparable to those we discussed earlier in this module for bullish views.

The first bearish approach we’ll discuss is the Bear Put Spread, which is the counterpart of the Bull Call Spread.

– Strategy notes

The Bear Put Spread is easy to set up. If you anticipate the market will be moderately bearish and decline around 4-5%, this strategy should be considered. It presents a window of opportunity to make a small profit should your outlook prove correct, while limiting losses if the market rises instead.

A conservative trader (read as risk averse trader) would implement Bear Put Spread strategy by simultaneously –

1. Buying an In the money Put option
2. Selling an Out of the Money Put option

The Bear Put Spread is not restricted to an ITM and OTM option creation – any two put options can be used. The aggressiveness of the trade depends on the strike selection. It’s worth noting that, for a successful implementation, both options should have the same underlying and expiry date, which we’ll illustrate with an example.

As of the current market rate, Nifty stands at 7485, which would make 7600 Put Option In the Money and 7400 Put Option Out of the Money. The ‘Bear Put Spread’ trade involves selling the 7400 PE and utilizing the premium received to partially fund buying the 7600 PE. The cost of purchasing the latter is Rs.165 while you will gain Rs.73 from selling the former – leaving a net debit of ____.

73 – 165

= -92

It is essential to take into account the payoff of this strategy as we explore its various expiry circumstances. Note that it is necessary for the trader to remain in these positions until expiry in order to get benefits from this.

Scenario 1 – Market expires at 7800 (above long put option i.e 7600)

This is an example of the market increasing, instead of decreasing like expected. Neither the 7600 nor 7400 put options would have any intrinsic value at 7800, so they will expire unused.

• The premium paid for 7600 PE i.e Rs.165 would go to 0, hence we retain nothing

• The premium received for 7400 PE i.e Rs.73 would be retained entirely

• Hence at 7800, we would lose Rs.165 on one hand but this would be partially offset by the premium received i.e Rs.73

• The overall loss would be -165 + 73 = -92

Do note the ‘-ve’ sign associated with 165 indicates that this is a money outflow from the account, and the ‘+ve’ sign associated with 73 indicates that the money is received into the account.

Also, the net loss of 92 is equivalent to the net debit of the strategy.

Scenario 2 – Market expired at 7600 (at long put option)

In this case, we presume the market ends at 7600, where we have bought a Put option. Thus, should the market close at 7600 both the 7600 and 7400 PE would be invalid (same as in situation 1) resulting in a loss of -92.

Scenario 3 – Market expires at 7508 (breakeven)

7508 is half way through 7600 and 7400, and as you may have guessed I’ve picked 7508 specifically to showcase that the strategy neither makes money nor loses any money at this specific point.

• The 7600 PE would have an intrinsic value equivalent to Max [7600 -7508, 0], which is 92.

• We have paid Rs.165 as premium for the 7600 PE and can recover some of this – 165 minus 92 equals 73. Therefore, our net loss on the 7600 PE at this stage is Rs.73 instead of Rs.165.

• The 7400 PE would expire worthless, hence we get to retain the entire premium of Rs.73

• So on hand we make 73 (7400 PE) and on the other we lose 73 (7600 PE) resulting in a no loss no profit situation

Hence, 7508 would be the breakeven point for this strategy.

Scenario 4 – Market expires at 7400 (at short put option)

We began this position at 7485, and as expected, the market has since dropped. Now both of our options present to us some intriguing prospects.

• The 7600 PE would have an intrinsic value equivalent to Max [7600 -7400, 0], which is 200

• We have paid a premium of Rs.165 and once this is compensated, we will retain Rs.35 from the intrinsic value of Rs.200.

• The 7400 PE would become worthless, so the entire premium of Rs.73 can be kept.

• The net profit at this level would be 35+73 = 108

The net benefit from this approach is in accordance with the general anticipation, resulting in a slight profit if the market falls.

Scenario 5 – Market expires at 7200 (below the short put option)

This time around the choices are intriguing, each with its own inherent worth. Let us figure out how the numbers stack up –

• The 7600 PE would have an intrinsic value equivalent to Max [7600 -7200, 0], which is 400

• We have paid a premium of Rs.165, which would be recovered from the intrinsic value of Rs.400, hence after compensating for the premium paid one would retain Rs.235/-

• The 7400 PE would have an intrinsic value equivalent to Max [7400 -7200, 0], which is 200

• We received a premium of Rs.73, however we will have to let go of the premium and bear a loss over and above 73. This would be 200 -73 = 127

• On one hand we make a profit of Rs.235 and on the other we lose 127, therefore the net payoff of the strategy would be 235 – 127 = 108.

Summarizing all the scenarios (I’ve put up the payoff values directly after considering the premiums)

It should be noted that the strategy yields a net payoff as anticipated, allowing the trader to benefit from a small gain if the market declines, while capping any losses in cases of an uptrend.

– Strategy critical levels

From the above discussed scenarios we can generalize a few things –

1. If the spot moves above the breakeven point, it will result in a loss, while if it moves below this threshold, there will be a profit.
2. Both the profits and loss are capped
3. Spread is difference between the two strike prices.
   1. In this example spread would be 7600 – 7400 = 200
4. Net Debit = Premium Paid – Premium Received
   1. 165 – 73 = 92
5. Breakeven = Higher strike – Net Debit
   1. 7600 – 92 = 7508
6. Max profit = Spread – Net Debit
   1. 200 – 92 = 108
7. Max Loss = Net Debit
   1. 92

You can note all these critical points in the strategy payoff diagram –

– Quick note on Delta

I neglected to mention this in the earlier chapters, however, better late than never! Always be sure to add up the deltas whenever you implement an options strategy. I personally utilized the B&S calculator for calculating deltas.

The delta of 7600 PE is -0.618

The delta of 7400 PE is – 0.342

The negative sign of the 7400 PE indicates that this put option’s premium will decrease if the markets increase, and rise if the markets fall. It is important to remember that the Delta would be affected accordingly.

-(-0.342)

+ 0.342

The combined delta of this position is the sum of the individual deltas. That is, it can be calculated by adding them together.

-0.618 + (+0.342)

= – 0.276

The overall delta of the strategy is 0.276, with a negative sign showing that premiums increase in falling markets. We can also tally up deltas from other strategies we’ve discussed, like the Bull Call Spread, Call Ratio Back spread and so on; they all have a positive delta, indicating a bullish view.

When it comes to strategies with more than two option legs, it can be hard to determine the overall perspective (bullish or bearish). An easy way to identify the bias is by adding up the deltas. If the sum ends up as zero, then the strategy is known as ‘Delta Neutral’, not leaning in any particular direction. We’ll discuss these kinds of strategies later on in this module.

It is noteworthy that delta neutral strategies, which are not impacted by the direction of the market, yet respond to modifications in volatility and time, are also referred to as “Volatility based strategies”.

– Strike selection and effect of volatility

Selecting strikes for a bear put spread is quite comparable to the approach employed for a bull call spread. If you’re not already aware of the ‘1st half of the series’ and ‘2nd half of the series’ strategy, I’d recommend checking out section 2.3.

If we are still within the early stages of this series, and anticipate that the market will dip approximately 4% from current levels, then it is best to select the appropriate strikes to build the spread.

It is logical to choose the next set of strikes when we get to the second half of the series. Making this selection would help form a spread.

I trust the two tables presented above will be helpful when selecting the put strikes for a bear spread.

Let us direct our attention to the influence of volatility on the bear put spread. Observe the image below –

It is evident that the higher the volatility, the greater the premium. Furthermore, it is also apparent that, as time passes, the premium increases.

• The blue line suggests that the cost of the strategy does not vary much with the increase in volatility when there is ample time to expiry (30 days)

• The green line suggests that the cost of the strategy varies moderately with the increase in volatility when there is about 15 days to expiry

• The red line suggests that the cost of the strategy varies significantly with the increase in volatility when there is about 5 days to expiry

It is evident from the graphs that volatility should be kept in mind near the end of the series. Taking a bear put spread is wise when expecting an increase in volatility, whereas it is best to abstain when a decrease is anticipated.