When it comes to making money in a bear market, the put option is the original classic. It may sound counter-intuitive, but you can make a pretty penny on falling stocks by picking the right options. But when the market doesn’t behave as expected, there’s nothing you can do but sit back and watch the money disappear, and put options are no exception.
This is where a put spread, or bear put spread, can minimize the amount of money at stake while keeping profits relatively unaffected. For reasons obvious enough, the put spread has remained a popular option among traders. Below I show you how a put spread simultaneously reduces risk and protects profits. You can pick up other market tricks with this option profit mini course.
The Put Spread
Before you can begin to understand put spreads, you need to have a solid understanding of calls and puts; thankfully, this blog post on call and put options can provide that.
A put spread is a strategy in which two put options are used for the same stock and for the same time frame. The trader of a put spread is expecting said stock to fall; that is what the trader is betting on.
A trader uses put spreads when he or she has faith that a particular stock is going to fall (preferably, at a moderate pace). This is exactly the opposite strategy involved in a bull call spread. Yes, a put spread limits the maximum amount of profit, but this is generally considered a fair trade because of the subsequent low-risk. You also have to keep in mind that you are making (or attempting to make) money on a falling stock. A limit is only natural. Learn more about the basics of trading with this introductory course to stocks, options and futures.
Buying and Selling
A put spread requires a trader to play two put options with the same expiration date. The first idea behind using two options is that it makes it a cheaper initial investment; if you buy one and sell one, you are offsetting the cost. More on this soon.
To be successful, one put option is purchased at a higher strike price and one put option is sold at a lower strike price. The option that is purchased will be further in-the-money than the one that is sold; technically, the options, particularly the option that is sold, can be at-the-money or even out-of-the-money. The exact numbers are completely determined by the trader’s preferences and the options that are available for purchase.
The first thing a trader needs to do is purchase a put option. Please note that at this time the trader does not need to own any of the stock in question; he or she just needs to own the option to sell the stock. If this is sounding too complex, bring yourself up to speed with this how-to-invest-in-the-stock-market class, or, at the very least, read this lucid article that addresses the ultimate investor’s question: how does the stock market work?
Let’s use imaginary company Corp. 1000 and let’s say that Corp. 1000 stock is trading at $50 per share. The trader is expecting the stock to drop below $50 per share in the next 30 days, so a put option should be purchased well above this estimate; say, $55 per share. Because this is so high, and goes against market predictions, it is going to be fairly expensive. Let’s imagine this will cost $1.50 per share to buy the put option contract. Just to clarify: at this time, shares are not being purchased, just the option to sell them is purchased. Because a single put contract is 100 shares, this will cost the trader $150.
Now the trader will go out and sell a put option, which another trader will purchase. Let’s imagine this put option is betting Corp. 1000’s stock will drop below $50 per share. Since this is a more reasonable estimate, it will not cost as much as the first option; the problem is that this is the option the trader is selling. So our trader might only be able to sell this option for $0.50 per share, or $50 per contract. Once this has been accomplished, however, the trader has attained a favorable position for a discounted price. Having bought one option for $150 and sold another for $50, his net loss is $100, or 33% less than it would have been if he had not sold the option.
Profits And Losses
How, then, does the trader make money? First, let us assume that everything goes according to plan. After 30 days, the price of Corp. 1000 stock is trading at $49 per share. Since the trader sold a put option, which will now be exercised by the buyer, the trader is contractually obligated to allow the buyer to sell his stock, which he will do for the agreed upon price of $50 per share. The trader must buy them from him for a grand total of $5000. And yes, that means we are now $5000 in the hole. Ouch.
But the trader immediately makes this money back. Having purchased the 100 shares for $50 dollars each, the trader turns around and exercises his own put option (at $55 per share), selling these 100 shares for a grand total of $5500. Nice.
The trader’s total profit, however, is not $5500 – $5000 = $500. Remember, he had to pay $100 to attain this position with a put spread, so the final profit is actually $400.
The trader can lose money if the stock price does not fall below $50 per share and the options are not exercised. Even in this worst-case scenario, the most the trader can possibly lose is the initial investment: $100. Thus, the risk is losing $100 and the reward is making $400.
If you know how to pick stocks, you can put the odds in your favor, which makes this strategy even sweeter (in other words, you will have a better chance at making $400 than you will of losing $100). But if picking the right stocks were easy, everyone would be doing it. Give yourself a clear advantage with this complete course to stock selection mastery.