Some of the most commonly used strategies by option traders are spread trades…
That has a lot to do with their versatility.
You can use spread trades to capture a wide range of market conditions – from when the market is gently rising or falling… or even if it’s just trading sideways instead.
A spread trade involves the simultaneous buying and selling of call (or put) options with different strike prices and the same expiry date.
We looked at these spread strategies just over a month ago, when I wrote about bull call, bull put, bear call, and bear put spreads.
If you haven’t had a chance to read them yet, I’d really encourage you to check them out… They’re great strategies to have in your toolbox.
Recently I received a letter about one of those strategies, the bear put spread, which I’d like to run through today…
Hi. Regarding your May 30 email, called “What to Do When You Think a Stock Is Going to Fall,” you described the bear put spread with several scenarios of the stock price going down. Could you also describe what we might do if the price does not go down (i.e., sideways or up)? When do we close the spread position, and when do we let it expire worthless? Thanks for all the education!
– Lance W.
Thanks for the question, Lance. Let’s get straight into it…
A Bear Put Trade in Action
To briefly recap, you typically use a bear put spread if you are bearish on a stock but are not convinced that it will fall heavily.
If you thought that this latter scenario was going to play out, then you would just buy a put option by itself.
The trade involves buying a higher priced put option (“A” on the chart below) whilst writing (selling to open) a put option at a lower strike price (“B”).
Please note that this chart of Tesla Inc. (TSLA) is only for illustrative purposes and is not a trade recommendation. (Also, for a detailed run-through of the numbers with this strategy, please click on the “bear put” link above…)
Tesla Inc. (TSLA)
Source: e-Signal
Because the second leg is further away (below) than the current stock price, you will receive less premium from the written put option than your outlay for the bought put option.
Meaning the net result is a debit to your trading account.
The reason for adding the second leg is that it lowers your total outlay compared to just buying the put option by itself. And in doing so, helps improves your breakeven position on the trade.
The downside is that it also limits your profit potential.
If your analysis proves right and the stock price falls, you would typically close out your bear put trade before expiry.
This reduces the risk of having to take delivery of the shares if your written put option leg is exercised early.
However, what happens, as Lance asks, if instead of the stock price going down as planned, it goes sideways or up as per the orange line on the above chart?
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When to Close the Trade
One of the major things you always need to remember with options is that the clock is always ticking…
While that might be handy when you’re writing an option, it works against a bought put option position.
Given that with a bear put spread the outlay for the bought put leg (“A”) is greater than the written put “B,” that means time decay plays an even bigger factor with this strategy.
That’s why you need to monitor your position closely…
If the position starts to go against you, you need to reassess the likelihood of your planned move coming off within your timeframe.
If you think the chances of that are increasingly slim, then it is often best to close out the trade immediately. Remember also that time decay accelerates the closer you get to expiry.
Meaning simply, the longer you leave it, the more time value (and premium) you are burning up.
Another way to play your exit is to set a stop-loss based on a fixed percentage…
So, for example, if your spread value drops by say 20% or 30% (or whatever you deem appropriate), then that can be a trigger to exit the trade.
Another strategy is to roll out of your existing position (again before you burn up too much time decay) into a new one with a later expiry.
However, given the limited profit potential of this strategy, and that you’ll be closing out your initial position at a loss, you need to be strongly convinced that your planned for move will still play out.
Finally, if your spread trade hasn’t worked out, and you believe there is little prospect of that before expiry, you’d only let the position expire worthless if the cost of closing the trade (broker commissions and other charges) exceeded the value of your position.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict