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Bear Put Spread

bear-call-spread

1. Definition

The Bear Put Spread, also known as Long Put Spread or Put Debit Spread, is known within the markets as “downward blockage”, and comprises a strategy for making money from prices drops in the underlying asset. The strategy involves selling ATM Puts at a certain level and buy OTM Puts at a higher pricing, both with the same expiration date. The strategy is similar to the Bear Call Spread, but uses Puts rather than Calls.

Selling a Put At-The-Money: selling a Put at a strike price close to the current share prices. Selling a Put forces you to buy a share until the expiry date at the strike price.

Buying a Put Out-The-Money: buying a Put at a strike price above than the current share prices. Buying a Put gives you rights of selling a share until the expiry date at the strike price.


2. Objective

Earnings from a market drop, or a neutral market. However, this strategy has a protection against an eventual upward move. This operations provides limited gains if the market drops, and limited losses in case of an upward trend. It’s widely used as a conservative option, when a market drop is expected. This strategy is attractive because buying the option gives leverage and reduces the cost of the option sales.


3. How it works

In this strategy, an ATM Put is sold, receiving a premium, and simultaneously an OTM Put is purchased, paying a premium. The initial position is negative, as premiums paid exceed those received. The graphs behave as follows:

Selling a Put + Buying a Put = Bear Put Spread

 

Selling a Put

gráfico Short Put_clean

+

Buying a Put

gráfico Long Put_clean

=

Bear Put Spread

gráfico Bear Put Spread_clean

Caption:

Red = Losses

Yellow = Losses from premiums paid

Green = Profits

Earnings: gains are alway limited, being larger as the downward trend is confirmed. The maximum earnings happen when share prices by the expiry date are equal or lower than the ATM Put’s strike.

Losses: also limited. They are larger as hikings are confirmed, but always limited. Maximum losses are equal to the net results of the operation, or the amount paid for the OTM options minus the credit received from the ATM options.


4. Example

Consider the following data:

Asset

Vale

Date

09/10/2013

Maturity

10/21/2013

Share prices

32,15

Days before the expiration

41

Number of options

1.000

To set up this operation, the investor should be selling a VALEV32 ATM Put, receiving a premium of  R$ 0.80 per option, and buying a VALEV33 OTM Put, paying a premium of R$ 1.34 per option.

Summary:

Type of option

Asset

Series

Number of options

Premium

Strike

Liquidation

Selling a Put

Vale

VALEV32

-1.000

R$0,80

32

R$ 800,00

Buying a Put

Vale

VALEV33

1.000

R$1,34

33

R$ – 1.340,00

Total

- 0,45

R$ – 540,00

By the expiry dates, results depend on the share prices as follows:

Share prices on the expiration

Selling a Put

Buying a Put

Results

R$ 27,00

-4.200

4.660

460

R$ 28,00

-3.200

3.660

460

R$ 29,00

-2.200

2.660

460

R$ 30,00

-1.200

1.660

460

R$ 31,00

-200

660

460

R$ 32,00

800

-340

460

R$ 33,00

800

-1.340

-540

R$ 34,00

800

-1.340

-540

R$ 35,00

800

-1.340

-540

R$ 36,00

800

-1.340

-540

R$ 37,00

800

-1.340

-540

R$ 38,00

800

-1.340

-540

Results:

If Vale’s shares reach less than R$ 32.00 by the expiry date, the investor shall exercise its Put option bought, selling the share for R$ 33.00. However, he will be also exercised and will be forced to buy shares at R$ 32.00, making profits of R$ 1.00 per share. But as the premiums balance was negative, profits drop to R$ 0.46 per share (R$ 33.00 – R$ 32.00 + R$ 0.80 – R$ 1.32 = R$ 0.46). On the other hand, if Vale’s shares are over R$ 33.00, the investor won’t exercise the selling options neither being exercised to buy shares, accumulating maximum losses of R$ 0.54 per share, price difference by reaching the Sale of OTM Put less Purchase of Put ATM (R$ 1.34 – R$ 0.80 = R$ 0.54). Look the graph below:

gráfico Bear Put Spread_pronto

Caption:

Red = Losses

Yellow = Losses from premiums paid

Green = Profits

Earnings: the operation makes profits if Vale’s shares reach less than R$ 32.40 (Share price – the premium paid). If they are lower than that, it is profitable, as any pricing below R$ 32.00 makes the investor to exercise rights of selling shares at R$ 33.00, but being exercised to buy some other shares at R$ 32.00. But the balance plus the premiums received generate earnings of R$ 0.46 per option, the best possible gains.

Losses: the investor lose money if shares exceed R$ 33.00, at a maximum loss of R$ 0.54 per option. Between R$ 32.40 and R$ 33.00 there are losses, but reduced accordingly with the prices by the expiry date. The maximum losses occur when prices are over R$ 33.00. Both options just expire and the balance of premiums is negative.

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