How it works: In the bear put spread strategy, the investor buys 1 in-the-the-money put option and sells 1 out-of-money put option of the same underlying stock for the same expiry date. The investor implementing this strategy is hopeful that the price of the stock will fall. The more it falls below the strike price of the put option purchased, higher the amount of profit, until the price falls below the strike price of the put option sold at which point the profit is maximum.
For example: On 2nd September 2013, the stock of Axis Bank Limited was trading at Rs. 860, you buy 1 in-the-money put option with a strike price of Rs. 900 at a premium of Rs. 77 and simultaneously sell 1 out-of-the-money call options with a strike price of Rs. 800 at a premium of Rs. 32. Both calls expiring on 26th September 2013. The net premium you paid on this trade is Rs. 45.
The table below will clarify the net payoff of the bear put spread strategy by assuming different spot prices on expiry:
(click to enlarge)
Risk/Reward: In the Bear Put Spread Strategy, your maximum risk will be to the extent of the net premium paid (i.e. Rs. 45 in our example). This happens if the stock price falls below the strike price of the in-the-money put option. Maximum profit will be made if the price of the stock closes at or above the strike price of the put option sold (i.e. Rs. 55 in our example).
Note that the put option sold (i.e. the out-of-the money option) brings down the cost of the trade but at the same time, it also caps the potential upside from the trade as once the price of the stock falls below the strike price of the put option sold, the investor starts losing money on it.
How to use the Bear Put Spread Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Bear Put Spread Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Axis Bank Limited put option contract is for 250 shares. Accordingly the net premium paid will be Rs. 11,250 for 2 lots (i.e. Rs. 45.00 *250) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of put option, you will have to deposit a margin of Rs. 30,700 (i.e. Strike price * Lot size * 15.35%) for selling/writing 1 lot of Axis Bank Limited put option. Note that the total value of your outstanding position in this case will be Rs. 2,00,000 (i.e. strike price * lot size).
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