In this article, I will introduce you the Bear Put Spread trade, the 4th in the vertical spread family. As you know, to take advantage of a down-trending market, you have 3 tactics to employ: short stock, short call and buy put. Buying put is the safest one of all 3 but it is not always financially feasible to trade a straight put. Some crazy high-price stock like MasterCard trading in the $300 range offer very expensive options. Also, implied volatility could be high and a crush could be imminent. This would potentially wipe out most of your options value. So, we will get around these problems by using Bear Put Spread. It benefits us in 2 ways:
- Using the market to finance our trade.
- Hedge or protect the trade from IV crush
We will sell lower strike options to reduce the cost of buying the higher strike one – market finance. Plus the mostly the premium lost in case of a crush will be covered by the short put. It is because the crush will effectively reduce the amount of money we need to spend to buy back the short. With that in mind, we will put on a real-life trade to get a clear picture of what we have been discussing. Says if you are bearish or thinking the Boeing Co (BO) will go down amid a massive production breakdown, you can use a Bear Put Spread such as:
Buy 1 BA Jan 11 67.5 for $2.75
Sell 1 BA Jan 11 62.5 for $1.43
Net debit of $2.75 – $1.43 = $1.32
Max Risk = Debit = $1.32
Max Reward = Distance between 2 strikes = 5 – 1.32 = $3.68
Since we have to buy at least 1 contract that controls 100 shares, Max risk and reward will be multiplied by 100.