Explanation

A bear put spread strategy is executed when a trader is moderately bearish on the market. Execution of a strategy entails 1 long position in a higher strike price (ITM) put option and 1 short put with a lower strike price (OTM). Both puts have the same underlying stock and the same expiration date. A bear put spread is established for a net debit. If the price of an underlying fall, ITM Put will start to make profits, and the OTM Put profit will be limited to the premium received. If in case the prices fall below the OTM strike, then it starts making losses which will be mitigated by ITM Put which generates profit.

Risk

Limited

Reward

Limited

Construction

Buy ITM Put Option

Sell OTM Put Option

Payoff Chart

Option Trading Example

Suppose that Bank Nifty is trading at 39600 levels and the trader is bearish on the market and expects the underlying to fall in the near future. He implements the Bear Put Strategy, he buys one Bank Nifty 39600 in the money (ITM) Put Option for a premium of Rs. 640 & sells one Bank Nifty 38600 out of the money (OTM) Put Option for a premium of Rs. 350. His net investment will be Rs. 11600. [(640 - 350) *40]

Scenario 1:

Suppose there was a scheduled Federal Reserve meeting and the rate hike was higher than expected, on that news Bank Nifty sold off and closed below the OTM put @ 38200, the trader will make a profit

Profit = gain on long put options – loss on the short put option

Rs. 35500 = [{(39600 – 38200 - 640) + (-38600 + 38200 + 350)} *50].

Scenario 2:

If the result from the Fed meeting wasn’t stark and Bank Nifty saw minimal losses and closed @ 40000, in such a scenario traders will make a loss of

Loss = loss premium paid for long put + gain on premium of short put

Rs. 11600 = [{(-640 + 350))} *40]