Playbook: Spreads: the Bear Put

Bear Put

The bear put is a vertical debit spread (you will have to pay for it). It is a long put ‘protected’ on the upside by a short put. The short put reduces also your cost. The disadvantage is that you cap potential on the downside, so you don’t want underlyings to go down very low (lost potential).

The long put you buy is ATM or ITM (-0.60 delta), so more expensive than the OTM short put (-0.40 delta) for which you get paid. Therefore it is a ‘debit play’ (you pay for the set-up).

You typically buy a bear put 3-6 months before expiration. The main reason is that you don’t want to be impacted by time decay (which is highest in the last month). In addition, your underlying must move downwards in order to reach the break-even point. So you want to give the pay more time to be right. And you want the breakeven point to be realistically achievable.

The bear put is the opposite of the bull call.

The position benefits most from IV/IVR expansion and/or moderate underlying price decreases to or slightly below the strike.

Considerations

General

The strategy looks to take advantage of a decline in price from the underlying asset before expiration.

Debit spreads are a way of buying expensive options that are good value at lower prices. 

Bear put spreads benefit from two factors, a falling stock price and time decay of the short option. Increased implied volatility may also benefit the bear put debit spread.

A bear put spread is the strategy of choice when the forecast is for a gradual price decline to the strike price of the short put.

These are the considerations for entering a bear put:

• The expectation that underlying (stock, ETF, index, future) will go down: the outlook is clearly bearish.
• Implied Volatility (IV)/IVR (IV Rank) is low (<30), looking for options to increase in value over time*
• You can make a better return than if you had bought a long put on the underlying.
• Executing a bearish trade for a capital gain at reduced maximum risk due to that you sell a put as well.
• It’s difficult to sell (‘short’) premium, so it is a leveraged alternative to selling/shorting the underlying.
• Bringing down the cost, risk, and breakeven on the trade compared to buying (only) the long put.
• Wanting to stay engaged after having reached maximum portfolio allocation for (e.g.) short premium strategies.
• The underlying has just experienced an increase, which gives you a strong entry.
• Hedging against bullish/long positions.
• Risk is limited (‘defined’) to the premium paid (‘debit’).
• The maximum reward is capped to the premium paid (‘debit’).
• When you buy and therefore own an option, you are exposed to time (value) decay (‘hurts’), so typically, expiration dates should be reasonably far away (so >90 up to 180 DTE or even higher) to give you more time and a chance of the option increasing in value; so the period to trade is at least three months, preferably longer.

* Note: because you’re both buying and selling a put, the potential effect of a decrease in implied volatility will be somewhat neutralized.

Vertical spreads reduce the position’s cost but limit your profits so that you can’t hit home runs. They work best when at-the-money options are less expensive than their out-of-the-money options. That can be measured by calculating the implied volatility of each option. For example, if the implied volatility of the option you purchase is 30%, but the out-of-the-money option you are writing has an implied volatility of 40%, you have a good play.

Description

Set-Up

1. ‘ Buy to open’ (BTO) the put option ( in US 1 contract = 100 shares) ITM at -0.60 delta (or ATM so above the underlying price but you don’t want to be too much exposure to time decay, theta)
2. ‘Sell to open’ (‘STO’) the put option at -0.40 delta, so lower, and below the underlying price. Since it is very difficult to find 40 delta set-ups fitting all criteria, I often skew towards ATM (-0.50 delta), but this further reduces my profit potential. The idea can also be to place this close to where you think the underlying will go.

• Sell the same number of strikes
• Arrange both put strikes equidistant from the underlying price, or skew for a better breakeven, to create a debit that’s (slightly more than) half the width of the spread.
• The further out-of-the-money the short put of the bear put debit spread is initiated, the more aggressive the outlook.
• Don’t go below 50% PoP.
• Intrinsic value long put>= Net debit (or: long put value – EXT long put (mid) >= Net Debit); to break even on the position, the stock price must be below the long put option by at least the cost/premium to enter the position.

Related Options Strategies

The bear put combines a long put with a short put at the same expiration date, and is one of the four vertical spread strategies (the other ones are: bull call, bear call, and bull put) and the basis for many other (horizontal and diagonal) spread and ratio strategies, long condors, and butterflies.

Long put positions perform well when the underlying makes big decreases in, in the short term. Bear put debit spreads require time to fully realize profits, so are medium- to long-term. They outperform long puts, as long as the underlying price decreases moderately and remains at or just above the short put, halfway to/near expiration. They are less expensive than buying only the lower put strike, and (may) result in a larger percentage of profit than purchasing only the lower strike (if the underlying price decreases moderately).

The Greeks

A bear put spread performs best when the price of the underlying stock falls below the strike price of the short put at expiration. Therefore, the ideal forecast is “modestly bearish” or “net negative delta.”

Because a bear put spread consists of one long put and one short put, the net delta changes very little as the stock price changes and the time to expiration is unchanged (“near-zero gamma”).

Bear put debit spreads benefit from an increase in the value of implied volatility. Higher implied volatility results in higher options premium prices. Ideally, when a bear put debit spread is initiated, implied volatility is lower than it is at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Since a bear put spread consists of one long put and one short put, the price of a bear put spread changes very little when volatility changes (“near-zero vega”).

Time decay, or theta, works against the bear put debit spread. The time value of the long options contract decreases exponentially every day (faster than the short put). Ideally, a large move down in the underlying stock price occurs quickly, and an investor can capitalize on all the remaining extrinsic time value by exiting the position. Since a bear put spread consists of one long put and one short put, the sensitivity to time erosion depends on the relationship of the stock price to the strike prices of the spread. If the stock price is “close to” or above the strike price of the long put (higher strike price), then the price of the bear put spread decreases with the passing of time (and loses money). This happens because the long put is closest to the money and decreases in value faster than the short put. However, if the stock price is “close to” or below the strike price of the short put (lower strike price), then the price of the bear put spread increases with the passing of time (and makes money). This happens because the short put is now closer to the money and decreases in value faster than the long put. If the stock price is halfway between the strike prices, then time erosion has little effect on the price of a bear put spread, because both the long put and the short put decay at approximately the same rate.

Entry Rules

Profitable bear puts require correctly selecting bearish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR below 30%.
• Bear put debit spreads can be entered at any strike price relative to the underlying asset. In-the-money options will be more expensive than out-of-the-money options.
• Ensure the trend is down/bearish: below SMA 20 and below the MACD line.
• Ensure at least three other technical momentum indicators are positive for a bearish trade (the more bearish the bias).
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bearish
2. Support & Resistance = the underlying has just experienced an increase to a clear resistance level
3. RSI = overbought
4. SMA 20 and MACD
5. Bollinger Bands in combination with Keltner Squeeze: at the top and outside Keltner bands
6. ADX/DMI: increasing up and above 20
7. ATR low

P/L and Risk Profile

Net Position

Net debit (premium bought minus premium sold), because you pay to buy the put option.

Theoretical Profit

The maximum reward is the difference in strikes (or ‘spread width’) -/- net debit (is/should be greater than net debit).

As the stock price goes down, the Bear Put moves into profit and reaches the maximum profit when the stock falls to the lower strike price.

The reward is capped/limited when the underlying price reaches the short put strike.

Theoretical Risk/Risk Profile

The maximum risk is the price you initially pay for the bear put (‘net debit/premium’) which is the difference between the net debit paid for the long put less the net credit received for selling the short put.

This is realized if the underlying price is above the long put.

Breakeven

Underlying higher strike -/- net debit.

Managing and Closing Position

Bear put debit spreads have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, or fast enough, or volatility decreases, the spread will lose value rapidly and result in a loss. Bear put spreads can be adjusted like most options strategies but will almost always come at more cost and, therefore, add risk to the trade and extend the break-even point.

Halfway to/Near Expiration

• If the underlying price decreases to/slightly below the short put (lower strike) profit increases because the short put is now closer to the money and increases in value faster than the long put (the spread widens): both puts are ITM and the profit = spread width – net debit (‘theoretical profit’).
• If the underlying increases below your stop/loss, sell the long put or close the position.
• If the underlying is between the put strikes and increases towards or above the long put (higher strike), the losses increase, because the long put is now closer to the money and increases in value faster than the short put.
• If the underlying is close to the long put(higher strike), losses further increase because the long put is closer to the money and decreases in value faster than the short put.
• If the underlying increases to above the long put (OTM): both expire worthless (OTM), and the loss will be the net debit (theoretical risk).

Rules for Managing/Adjusting Position

• Set alerts on breakeven/predetermined targets.
• If the PoP is <33%: manage or close
• 1% rule: stock within 1% or short put/call: manage the position.
• At 21 DTE.
• If the underlying price goes against you, so increases:
  • roll the untested short put up for extra credit (same expiration), but never above breakeven.
  • or, if the underlying price goes up/increases fast: ‘leg out’ (BTC) the untested short put for a fractional debit and hold the long put (if you expect an increase in the underlying price).
  • or, a bull call debit spread could be added at the same (long) strike price, and expiration as the bear put spread. This creates a reverse iron butterfly and allows the call spread to profit if the underlying price continues to increase. However, the additional debit spread will cost money and extend the break-even point.
  • or close position, and open bull call (, or bull put), based on the same entry rules you use normally.
  • or check whether you can do a ‘pendulum adjustment’ by selling the long and buying the long on the other side when between strikes:  so creating a bull put (don’t roll the short: this will be at a cost and makes no sense (ITM, you want OTM).
• If the underlying price is going in the right direction, so decreases:
  • never leg out if the underlying price goes down/decreases fast: lock in profits by purchasing the call counterpart (for a fractional debit), adding risk to the initial strategy, neutralizing the portfolio’s ∆β to rebalance (improve the statistical edge).
  • if the underlying asset is expected to continue to fall strongly beyond the strike price of the short put option, one could also choose to buy to close the out-of-the-money short put option and then simply allow the long put option to continue to gain in value.
  • if you have seen a large percentage of profit on a spread that still has a lot of time left, you could elect to take profits and buy a new spread that is further away (even lower strikes).
• Never roll the entire spread out in time.
• Contrary to the credit spread you can NOT buy back only the short put. 
• If all this is not workable: allow the limited risk probabilities to play out, or close the position.

Rules for Closing Position/Exiting the Trade

• For a 50% profit
• Close before the final month before expirations (to avoid time decay), so not later than around 35 – 21 DTE.

Mitigating a loss

• To hedge/recover losses you open a high probability position, using a strategy that favors neutralizing the portfolio’s ∆β, to rebalance and create an overall statistical edge, reduce costs or maintain profits (this is always the goals when adding risk to manage limited risk strategies).
• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% of the premium paid; if the underlying rises above the stop loss, exit by selling the put.

Additional Notes

Advantages

• Reduced risk, cost, and breakeven point for a medium- to long-term bearish trade
• Cheaper than buying the stock or buying a put alone.
• Capped downside/risk
• The farther away from expiration, the more downside protection in the event the stock increases rapidly.

Disadvantages

• Only higher yields if you select significantly lower strikes AND the underlying stock price decreases to the lower of those strikes.
• Capped upside if the stock goes down (loss of opportunity).
• The farther away from expiration, the slower the maximum returns made ( = price one pays for downside protection).

Exercise/Assignment

The short put can be assigned in the event it is ITM. This results in (probably unwanted) stock.

The risk of early assignment is a real risk that must be considered when entering into positions involving short options. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bear put spread (the lower strike price), an assessment must be made if an early assignment is likely.

If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before assignment occurs, the risk of assignment can be eliminated in two ways:

1. First, the entire spread can be closed by selling the long put to close and buying the short put to close.
2. Alternatively, the short put can be purchased to close, and the long put can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put. Or close the 100 long shares and a long put as a single Covered Stock order.

Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Source: Fidelity Learning Centre

The long put can be ‘exercised’. For this, you need to contact your broker.