Options traders who are bearish on a particular security can use a Bear Put Spread strategy to cash in on downward movement in the security. The risk is a loss of the contract price, and that risk is all front-loaded. If the price rises, the contract price will be lost. If the price of the security declines, the trader will realize a gain.
A put option is an option to sell a security at the specified strike price. By buying a put, the investor acquires the right to sell at a higher price, but this comes at the cost of a premium reflected in the option price. The premium is larger than the difference between the current market price and the strike price. The seller of a put option agrees to buy the underlying security at the strike price.
To use the bear put spread, a trader simultaneously buys a put contract at one (higher) strike price and sells a put option at a lower strike price. These two contracts therefore give the trader offsetting obligations in terms of the underlying security. If the price of the security stays the same or increases, both of the puts will end up out of the money and will not be executed. If the price of the security falls below the lower strike price, the trader has acquired the right to sell at the higher strike price and the right to buy at the lower strike price.
Imagine that a security is trading at $50 and the trader is convinced that the security will decline in value in the short to medium term. In the hypothetical example, assume that prices for puts at $50 and $55 strike prices are $4 and $6 respectively. The investor buys a put at a $55 strike price and sells a put at a $50 strike price. The upfront cost is $200: (100 * ($6 – $4)). If the security increases in value so that both puts are out of the money, both puts will expire worthless and the total loss on the investment is that up-front investment.
On the other hand, if the security price declines to a level below the lower strike price (less than $50 in this example) then the investor can exercise both options. In that case, the investor makes $500 on the execution: (100 * (55 – 50)). The return on the investment is the $500 gained on the execution minus the $200 up front contract price, or $300. In this case, the trader makes a $300 on an up-front investment of $200. Not a bad profit. The strategy only works if the price falls so that both options are in the money. If not, the options expire worthless and the trader is out the difference between the two options prices.