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Bearish Put Price Spread | Option Derivative Strategy

Introduction

Price spread strategy involves simultaneously buying and selling similar kind of options on the same underlying asset having same maturity/expiry date but with different strike price. That means, this strategy involves two option contracts with two different strike price creating a range having lower strike price and an upper strike price. This strategy is generally for those investors who have moderate price belief as it reduces the loss at the cost of limited gain.


Bearish PUT Price Spread involves buying a PUT option at higher strike price and simultaneously selling/writing a PUT option at a lower strike price on the same underlying asset having same maturity/expiry date.​


Let us understand what is Bearish PUT spread strategy using an example-

Consider an investor who is bearish on stock and expects the share price will fall below $500. His investment horizon is 1-year. Following information is available –

Share price is currently trading at $520

PUT option at strike price of $500 is currently trading at a premium of $45.70

PUT option at strike price of $420 is currently trading at a premium of $17.72


Case – 01: Buying a PUT Option

Investor is bearish on stock and expects the share price will fall below $500 on expiry. He can simply buy a PUT option at a strike price of $500 by paying premium of $45.70.

Initial premium outflow = $45.70.

Break-even point = Strike price – Initial premium paid = $500 - $45.70 = $454.30


Situation – 01: If the share price on expiry happens to be $550

PUT option lapses.

Payoff on expiry would be $0

Loss on expiry would be initial premium paid = $45.70


Situation – 02: If the share price on expiry happens to be $430

PUT option gets exercised in favour of the investor.

Payoff on expiry would be strike price minus share price = $500 - $430 = $70

Profit on expiry would be payoff minus initial premium = $70 - $45.70 = $24.30


Situation – 03: If the share price on expiry happens to be $400

PUT option gets exercised in favour of the investor.

Payoff on expiry would be strike price minus share price = $500 - $400 = $100

Profit on expiry would be payoff minus initial premium = $100 - $45.70 = $54.30


Situation – 04: If the share price on expiry happens to be $300

PUT option gets exercised in favour of the investor.

Payoff on expiry would be strike price minus share price = $500 - $300 = $200

Profit on expiry would be payoff minus initial premium = $200 - $45.70 = $154.30


Therefore, under PUT option

Maximum Loss = Initial premium paid = $45.70 [ maximum loss is limited ]

Maximum Profit = Share price – Initial premium paid [ maximum profit is unlimited ]

Break-even point = Strike price – Initial premium paid = $500 - $45.70 = $454.30


Case – 02: Simultaneously buying and selling PUT Options

Investor is bearish on stock and expects the share price will fall below $500. At the same time he is non-bearish below $420. This means that the investor is expecting the share price will remain between $420 and $500 on expiry. He can do so by buying a PUT option at a strike price of $500 by paying premium of $45.70 and simultaneously sell/write a PUT option at a strike price of $420 for which he will receive PUT premium of $17.72.


Initial premium of $45.70 involves right to have option below $420. Since investor is non-bearish on stock below $420, why to pay additional cost of holding the position? Therefore, selling/writing a PUT option at a strike price of $420 will result in initial premium inflow of $17.72.

Net initial premium outflow = Premium paid on $500 PUT – Premium received on $420 PUT = $45.70 - $17.72 = $27.98.

Break-even point = Higher strike price + Net initial premium paid = $500 - $27.98 = $472.02.


Situation – 01: If the share price on expiry happens to be $550

Both CALL option lapses.

Payoff on expiry would be $0

Loss on expiry would be net initial premium paid = $27.98

Situation – 02: If the share price on expiry happens to be $430

$500 PUT option gets exercised in favour of the investor while $420 PUT option lapses.

Payoff on expiry on $500 PUT option would be strike price minus share price = $500 - $430 = $70

Profit on expiry would be payoff minus net initial premium paid = $70 - $27.98 = $42.02


Situation – 03: If the share price on expiry happens to be $400

$500 PUT option gets exercised in favour while $420 PUT option gets exercised against the investor.

Payoff on expiry on $500 PUT option would be strike price minus share price = $500 - $400 = $100 (exercised in favour)

Payoff on expiry on $420 PUT option would be strike price minus share price = $420 - $400 = $20 (exercised against)

Therefore, net payoff from the strategy = $100 - $20 = $80

Profit on expiry would be net payoff minus net initial premium paid = $80 - $27.98 = $52.02


Situation – 04: If the share price on expiry happens to be $300

$500 PUT option gets exercised in favour while $420 PUT option gets exercised against the investor.

Payoff on expiry on $500 PUT option would be strike price minus share price = $500 - $300 = $200 (exercised in favour)

Payoff on expiry on $420 PUT option would be strike price minus share price = $420 - $300 = $120 (exercised against)

Therefore, net payoff from the strategy = $200 - $120 = $80

Profit on expiry would be net payoff minus net initial premium paid = $80 - $27.98 = $52.02


Therefore, under Price Spread Strategy

Maximum Loss = Net initial premium paid = $27.98 [ maximum loss is limited ]

Maximum Profit = Difference of strike price – Net initial premium paid = ($500 - $420) - $27.98 [ maximum profit is limited ]

Break-even point = Higher strike price - Net initial premium paid = $500 - $27.98 = $472.02.

Benefits of Price Spread Strategy

  • Under situation – 01 of both the cases, the loss of initial premium paid is lower in Price Spread Strategy as compared to buying only PUT option in case – 01 [ lower initial premium resulting in lower loss ].

  • Under situation – 02 of both the cases, the profit from the Price Spread Strategy is higher as compared to buying only PUT option in case – 01 [ higher profit on expiry because of lower initial premium ].

  • Under situation – 03 of both the cases, the profit from the Price Spread Strategy is higher as compared to buying only PUT option in case – 01 [ higher profit on expiry because of lower initial premium ].

  • Break-even point in Price Spread Strategy is higher as compared to buying only PUT option in case – 01 [ faster break-even because of lower initial premium ].


Drawbacks of Price Spread Strategy

  • Under situation – 04 of both the cases, the profit from the Price Spread Strategy is lower as compared to buying only PUT option in case – 01 [ lower profit on expiry because of loss in writing a $420 PUT option ].


Recommendation to the investor

Bearish PUT Price Spread Strategy should only be employed if an investor expects the share price to remain between a particular range of strike price (in our case, $420 to $500). If the share price falls steeply (say share price on expiry rises to $300, $200 . . . and so on), the profit from the Price Spread Strategy is limited to $52.02 while in case – 01 i.e., buying only CALL option, profits can result in up-to zero share price level.

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