Bear Spread with Put Options

Bear Spread with Put Options

The Bear Spread with Put Options involved writing a low underlying strike price K1 put option and buy-in a higher  underlying strike price K2 put option. The assumed current underlying asset price is higher than K2.

Bear Spread with Put Options

Bear Spread with Put Options with Higher Underlying Asset Price

 Bear Spread with Put Options K60 K2 55 K1 50

(compute based on: put option volatility 54%, risk free rate on options 10%, K $60, K1 $50, K2 $55, period 6 months, present value of initial cashflow neglected, equity)

Profit from Bear Spread with Put Options K >> K2 >> K1

 The purpose is to profit as long as stock price is below K2 after compensating for initial cash outlay represented by cost of long put option and income generated by writing put option.

Given that time to expiry is the same for both options, the higher strike price put option will be price higher than the lower strike price put option.

Let us assume P1 be the write price of put option with underlying strike price K1 and P2 be the buy-in price put options with underlying strike price K2.

Bear Spread with Put Options

Profit Table

Initial Cash Outlay = P1 – P2 (P1 << P2)

Underlying Price Range Payoff from Long Put Option at K2 strike Payoff from short Put Option at K1 strike Total Payoffs
ST ≤ K1 K2 – ST -(K1 – ST) K2– K1 + P1 – P2
K1 < ST < k2 K2 – ST 0 K2 – ST + P1 – P2
ST ≥ K2 0 0 P1 – P2

 

In the model of Bear Spread with Put Options, there will be a loss resulting from initial cash outlay if underlying asset prices rises above K2 after expiry of options. There will be profit if price of underlying ends below K1. This profit comes entirely from cash inflow from writing put option after deducting cost of buying put options.

Three types of Bear Spread with Put Options can be distinguished

  1. Both puts are initially out of the money
  2. One put is initially in the money; the other call (put) is initially out of money
  3. Both puts are initially in the money

The highest risk and reward Bear Spread with Put Options comes from type 1. They cost very little to set up because they are out of the money but have small probability of giving high payoffs K2 – K1 + P1 – P2 (where P1 << P2 and P1😛2 => 0)

Bear Spread with Put Options with Lower Underlying Asset Price

 Bear Spread with Put Options K45 K1 50 K2 55

(compute based on: put option volatility 54%, risk free rate on options 10%, K $45, K1 $50, K2 $55, period 6 months, present value of initial cashflow neglected, equity)

Profit from Bear Spread With Put Options K << K1 << K2

Best Options Trading for Dummies profits on Bear Spread with Put Options with Options Trading 101.