A put debit spread, or bear put spread, involves buying a put option and simultaneously selling another put option with the same expiration date but a lower strike price.
This strategy is employed by traders who anticipate the underlying asset's price to decline. The primary objective is to capitalize on the variance in premium between the two put options, and the potential maximum loss is restricted.
BEARISH STRATEGY
In a put debit spread, the goal is to profit from a potential downward movement in the price of the underlying asset.
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The strategy benefits from a decrease in the underlying asset's price, and the maximum profit occurs if the price falls below the lower strike price at expiration.
LIMITED PROFIT & RISK
The maximum profit in a put debit spread is limited.
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It occurs when the underlying asset's price is above the higher strike price at expiration.
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The risk in a put debit spread is limited to the initial net premium paid to enter the trade.
TIME DECAY DISADVANTAGE
Time decay works against the position.
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All else being equal, the value of the options will erode as time passes.
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Therefore, it's generally more profitable if the underlying asset makes its move sooner rather than later.
PROS | CONS |
Limited Risk: The maximum loss is predefined and limited to the initial cost of the put debit spread. | Limited Profit Potential: The capped profit potential means you may miss out on significant downward movements in the underlying asset. |
Defined Profit Potential: Profit potential is capped, providing a controlled approach to trading. | Possibility of Loss: If the underlying asset does not move as expected, you could incur a loss equal to the initial cost of the put debit spread. |
Bearish Market Strategy: Well-suited for a bearish outlook on the underlying asset, making it an effective strategy in a declining market. | Market Direction Dependency: Most profitable in a bearish or stable market, put debit spreads are vulnerable to upward market movements, and losses may occur in a bullish market. |
Margin Efficiency: Generally has lower margin requirements compared to buying a naked put option. | Time Decay Disadvantage: As time passes, the value of the options decreases, potentially leading to a reduction in the overall value of the put debit spread. If the underlying asset doesn't move in the desired direction quickly enough, the time decay can erode the profitability of the trade. |
PUT DEBIT SPREAD AND OPTION ASSIGNMENT
Assignment risk is also a consideration in put debit spreads. In a put debit spread, assignment risk occurs when the short put option gets exercised by the option holder. If the short put option is exercised, the trader who sold the option is obligated to buy the underlying asset at the specified strike price. This could result in the trader having to take delivery of the underlying shares or sell the shares at the market price to fulfill the obligation.
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For put debit spreads, the risk of assignment typically arises if the price of the underlying asset is below the strike price of the short put option at expiration.
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In such a scenario, the buyer of the put option may choose to exercise it to sell shares at the higher strike price.
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To manage assignment risk, traders employing put debit spreads may choose to close out the position before expiration if it becomes likely that the short put will be in the money.
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Alternatively, they could roll the position by closing the existing spread and opening a new one with a later expiration date.
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This helps to avoid the potential complications and costs associated with assignment while allowing the trader to maintain their bearish position in the market.
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PUT DEBIT SPREAD EXAMPLE
Suppose an investor holds a bearish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bullish outlook involves the execution of a call debit spread. In this scenario:
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Buys for $2.46 one put option with a strike of $350 expiring in nine days
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Sells for $1.01 one put option with a strike of $347.50 expiring in nine days
This strategic move results in a net debit of $1.45 for the pair of options, derived from the $1.01 credit from the sale minus the $2.46 premium paid for the purchase. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall debit accumulated stands at $145.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences a downtrend, reaching $347.50 at the time of expiry. This results in the attainment of maximum profit, amounting to $105. The calculation involves subtracting the short strike ($350) from the long strike ($347.50) followed by subtracting the price of the long strike ($2.46) from the price of the short strike ($1.01), and then multiplying the result by the number of shares (100). Hence, $350 - $347.50 is equal to $2.5, and $2.46 - $1.01 equates to $1.45, leaving us with $2.5 - $1.45 = $1.05 and $1.05 multiplied by 100 shares equals the peak profit of $105.
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($350 - $347.50) - ($2.46 - $1.01) = $1.05 x 100 shares = $105
It's important to note that once the stock surpasses the upper strike price, the strategy plateaus, and no additional profit accrues beyond this point.
MAXIMUM LOSS SCENARIO
Should the DIA shares hover at $350 or climb above the designated upper strike, the maximum loss comes into play. Yet, this loss is confined to a maximum of $145, calculated as the difference between the price of the long strike ($2.46) and the price of the short strike ($1.01) multiplied by 100 shares.
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$2.46 - $1.01 = $1.45 * 100 = $145
The investor's undesirable scenario envisions the stock concluding above the $350 per share mark upon expiration, thus marking the potential loss for this investor of $145.
BREAKEVEN POINT
The breakeven point for a put debit spread is the long put strike price minus the net debit paid.
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Net Debit Paid per Share: $1.45
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Long Put Strike Price: $350
The breakeven point for this put debit spread is $348.55, which is obtained from the Long Put Strike Price of $350 minus the Net Debit of $1.45. This means that at expiration, if the price of DIA is at or below $348.55, the investor will start to make a profit. Above $348.55, the investor will incur a loss, with the maximum loss occurring if DIA remains at or above $350.
In summary, the put debit spread strategy is designed for traders anticipating a decline in the underlying asset's price. By purchasing a put option while simultaneously selling another put option at a lower strike price, this approach allows for limited risk with a defined maximum loss. Profit potential is capped, occurring if the asset's price falls below the lower strike price at expiration. Time decay, however, can erode profitability if the expected market movement does not occur swiftly. Despite its limitations, the put debit spread remains a valuable tool for bearish market strategies, offering a controlled approach to trading with clear risk management benefits.
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- Bear put spread. (n.d.). www.fidelity.com/learning-center/investment-products/options/options-strategy-guide/bear-put-spread.
- Market Chameleon. (n.d.). marketchameleon.com/Learn/Option-Strategies/Debit-Put-Spread.
- Schaeffer. (n.d.). How to trade vertical spreads: put debit spreads. Nasdaq. www.nasdaq.com/articles/how-to-trade-vertical-spreads:-put-debit-spreads.
- Team, C. (2023, November 22). Bear put spread. Corporate Finance Institute. corporatefinanceinstitute.com/resources/derivatives/bear-put-spread.
- Bear put spread. (n.d.-b). www.optionseducation.org/strategies/all-strategies/bear-put-spread.
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