When you think a stock or index is about to fall, the best way to trade it is not always clear…

You could short the stock or index directly… But some folks don’t have access to an account that allows that.

Another choice is to buy a put option. A put option increases in value when the underlying security falls.

Yet options have expirations… And although you might get your analysis right, the move might take longer than you expected. Or the stock might not fall far enough to make your put option trade profitable.

That’s where another options strategy, a “bear put spread,” can help increase the chances that your trade will be successful…

Improving Your Breakeven

As the name implies, a bear put spread means that you are bearish about the underlying security and are using put options. A spread means you’re going to buy and sell put options simultaneously.

For the first leg of the trade, you buy a put option. For the second leg, you’ll write (sell) a put option at a lower price. Both options should have the same expiry.

As we saw recently in our discussion of the bull call spread strategy, adding the second leg reduces the move you need to get to breakeven…

In other words, the stock needs to fall less (compared to just buying a put option) for your trade to be successful.

The downside is that this strategy limits your profit potential.

So let’s see how you might put a bear put spread into action. (Note: This is an example and not a trade recommendation.)

Below is a chart of the Invesco QQQ Trust Series 1 (QQQ)…

Invesco QQQ Trust Series 1 (QQQ)

Source: e-Signal

After a strong run-up, the Relative Strength Index (RSI) shows that QQQ is overbought (red circle). So you decide that you want to place a short trade to capture a potential mean reversion.

You might not be overly confident of a huge move down. But you still think that QQQ is vulnerable to a pullback if the RSI rolls over and starts heading lower.

So, in this example, you could place a bear put spread by buying a QQQ put at $330 for $5 (level ‘1’, upper orange line). At the same time, you write (sell) a put at $320 (level ‘2’, lower orange line) for $3.

You’ve paid out $5 for the bought put option and received $3 for the sold put, so you’re out of pocket $2 for the spread trade. (Remember, each options contract represents 100 shares. So that $2 equates to $200 per contract.)

Your breakeven on the trade is now $328. That’s the bought put strike price ($330) minus the $2 you have to recoup. That means QQQ has to fall below $328 for your trade to become profitable.

Had you just bought the put by itself, QQQ would have to fall further ($325) for you to break even. (That’s the $330 strike price minus the $5 you need to recoup before the trade becomes profitable.)

Playing the Odds

By placing a spread, you’ve reduced your total spending from $5 to $2… and you’ve reduced the distance QQQ needs to fall for you to break even.

However, this also puts a cap on your profits… You can make up to the $10 difference between your options’ strike prices ($330 and $320), minus the premium you paid out to open the position ($2).

So the most we can make on this trade is $8 – which equates to $800 per contract. Even if QQQ fell to $300, our profit on this trade is capped at $8.

Yet giving up the chance of bigger profits comes with an increased likelihood of success.

And this strategy significantly reduces the capital you need to make a trade, which becomes increasingly important once you begin to make multiple trades.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

Mailbag

Recently, we’ve shared about bear call spreads, bull put spreads, bull call spreads, and now bear put spreads.

If you’ve found these strategy breakdowns helpful, we’d love to hear about it. Or if there’s another strategy you’d like to see us explore, let us know! Send in your thoughts to feedback@opportunistictrader.com.