Options Education: Put Options and the Bear Put Spread

Put options give the buyer the write to sell a stock at a stated price by a stated date, but not the obligation to exercise their option.  At its basic principal, taking a long position in a put option, the buyer believes the underlying stock will drop in value.  Since put options are one type of derivative, this means the value of the option is based on the value of the underlying asset (the actual stock).  As the price of a stock drops, the value of the put option would increase in price.  So in way (ignoring time premiums) options pricing will fluctuate up and down just like the price of a stock.   1 put option contract is equivalent to control in 100 shares of a stock, this is significant leverage.  Think of buying a house and imagine a world where you could only pay cash for a home.  There would be significantly fewer home owners.  With financing (leverage), you can put a small down payment of say 10%, finance the other 90%, to get control of the house.

When looking at options pricing, multiply the price you see quoted by 100 to get your cash outlay for the trade.  If purchasing multiple contracts, you will also multiply by the number of contracts you are taking a position on.  For example. you see a put option for XYZ with an asking price of $1.50 and you want to buy 3 contracts.  Your cash outlay would be $450 ($1.50 x 100 x 3).

(There are other concepts that you should know about options, such as intrinsic value and speculative/time premium, but for this particular article, we will assume the readers have this understanding.)

There are several put option strategies that a trader can execute.  Today we will look at 2 particular put strategies speculating on the drop in value of a stock and compare the advantages/disadvantages of both.

Put Option Buying

The outright buying (without actual ownership of the actual stock) of a put option is a simple enough trade to execute.  You establish your position by buying to open the position.  The purchase of a put option is essentially looking for the drop in the price of a stock.  Maybe a company has had an unbelievable run in share price and you think the price is getting ahead of itself, and should be due for a correction.  Maybe you think the company will miss its earnings estimates and drop after reporting.  Instead of taking a short position of a stock, which would require a much larger initial cash outlay, you can simply purchase a put option and benefit from the leverage provided by options.  Another benefit of purchasing a put option over shorting a stock is the cap on how much you can lose.  With shorting a stock, your losses are theoretically unlimited if a stock was to continuously increase in value and you didn’t close your trade.  With just buying a put option, your losses are limited to your cost to establish the position.

Another thing readers should know, you can sell your position in the put option when you feel it is necessary.  So you purchase a put option and it increases in value 20%, you can simply sell the put on the market and book your profit.

With any option trade, it is important to understand the maximum profit/loss potential of the trade, along with your break even point as well.

First is a key for my abbreviations below:

P=profit

L=loss

E=Exercise Price or Strike Price

p=put option premium or cost of the put

S*=stock price

First lets look at the maximum profit of a put option purchase.  Since buying a put means you are looking for the price of the stock to go down, the maximum profit for a put option occurs when the stock hits $0.  Mathematically this looks like: Maximum Profit=Put Exercise Price-Underlying Stock Price-Put Option Premium Paid.  Since maximum profit occurs when the stock price hits $0, the formula can be further reduced to:

Max Profit= Exercise Price-Put Premium or Max P=E-p

Maximum loss on a put option purchase occurs when the price of the stock trades higher than the exercise price.  In other words, the maximum loss is what you paid for the put option.  Or mathematically, when Stock Price>or= Exercise Price, max loss is put option premium.

Max L=-p

Break even point occurs when you are able to cover the cost of the put option.  This is represented by: Break Even=Exercise-Put Option Premium or Break Even=E-p

Don’t worry, I’ve created the below Excel Spreadsheet to make the above calculations easier for you.  Just download the file and enter in your variables.

Looking at the above spreadsheet, you can easily calculated the max profit, max loss, and break even for your long put position.  Only modify the variables at the top.  Once you plug in the strike price, put price and increments you would like to see the profit and loss calculated, the calculations will update.  Any highlighted numbers should not be modified as the formulas will be messed up.

Below is the profit and loss chart for any outright put option purchase.

Notice, as you follow along the X axis and the stock price goes down, your profit starts to rise and maxes out as the stock price hits $0.

Now lets look at TSLA stock.  They have had a crazy run up.  Lets say you wanted to speculated the price could drop in value and you wanted to try to capitalize on a decrease in the price.  You narrow down your option choices to a few contracts in the 800 or 750 strike price range.  You also look at May 15th contracts as that will capture an earnings report that will take place on April 22, to try and give a chance of a negative event occurring to lower the price.

Enter the Strike price of 800, Put Premium of 103.50, and Current Stock Price of $950 to get your calculations.

Keep in mind you have purchased an out of the money put option, so the intrinsic value of the option is $0, you are simply paying $103.50 for the time from now until the May 15th expiration.  But as the price of TSLA drops and approaches (or goes below) the $800 strike price, your option starts to add an intrinsic value.

Fast forward to the current price of TSLA at $748.07.  When you look at the May 800 Put, the current price is at $148.73.  The stock has fallen below the $800 strike price.  Since your put option is now in the money, the intrinsic value has increased by $50, a couple days has passed meaning the option has lost a little of its time premium.

To exit the trade, you now can sell your put option and pocket a $45.23 profit.  Don’t forget to multiply the value of the contract. So profit of $45.23 times the number of contracts (1 in this case) times 100 shares, resulting in a profit of $4523.  Your initial cost would have been $10,350 (103.50x1x100).  The return on this trade is 43.70% (45.23/103.50).

The result of the trade and the time frame being under 1 year is a short term capital gain, taxed at your ordinary income tax rate.

Bear Spread Using Puts

Say you were anticipating a drop in the price of a stock, but you were not quite sure about placing an outright put option trade described above.  The above trade would have cost you just of $10k to establish, which is also your maximum loss.  You still want to position yourself for a drop in the price of a stock, but maybe you want to reduce the capital outlay.  A bear spread using put options would be something to consider.  A bear put spread is established by buying 1 put option at a higher strike price, and also shorting 1 put option at a lower strike price.  By shorting the lower strike put option, you are receiving a credit to the transaction, thereby lowering the cost of the trade.

There are no free trade offs however.  With the lower outlay to establish the trade, a bear put spread will also limit the potential return you can make on the overall trade.

As the price of the stock drops, you make money on the higher strike Put contract, but you begin to lose money on the lower priced put option that you have shorted.

As with options trades, you always want to know the Max Profit, Max Loss, and Break Even points.

The maximum loss is calculated as: Long Put Option Premium-Credit from Short Option Premium

The maximum profit is calculated: (Long Put Strike-Short Put Strike)-(Long Put Premium-Short Put Credit)

Breakeven is calculated: Higher Put Strike Price-(long put premium-Short Put Credit)

Below is a simple excel spreadsheet, so you can plug in your variables:

And now the typical profit and loss profile for a bear put spread:

In the above example, we buy a put option with a strike price of $60 which cost us $7 per contract.  To make this a bear spread, we also have to short a put with a $50 strike price and collect the $2 premium.  Short selling is basically, selling something you don’t own.  Plugging in the variables into the spreadsheet, we see our maximum gain is $5, maximum loss is $5, and the breakeven price for this trade is $55.

Now lets use TSLA shares to compare our Bear Spread vs an outright Put Purchase.

Tesla stock is trading at a price of $950.  We have determined to create a bear spread using the May 800 and 750 puts. The May 800 put will cost us $103.50 per contract, the May 750 will provide us a credit $81.90 (remember, this is the short put contract of the trade).

Lets plug in our variables into the excel calculator.

Long Put Price 800, Long Put Premium $103.50, Short Put Strike Price 750, Short Put Premium 81.90.

The max gain on this trade is $28.40, maximum loss is $21.60, and the breakeven price is $778.

Out cash outlay for this trade is also the maximum loss potential of $21.60.

With the drop in price of TSLA to $748.07, our trade would reach the maximum profit potential and the trade should be closed out.  The current price out the May 800 PUT is $148.70 and the May 750 PUT is $119.15.  Netting out the Gain of $45.20 on the 800 Put and the loss of $37.25 from the 750 put, this trade provided a return of $7.95.  In the real world, the bid ask spread on options can at times be substantial and this cuts into profits.  Our total return on this trade is a return of  36.80% (7.95 profit/the initial cost of the trade $21.60)

Comparing the 2 Trades

Both the outright Put purchase or going with a Bear Put Spread are counting on drops in the price of the underlying asset.  The outright purchase of a PUT does offer the ability to make a higher overall dollar return and percentage return, however the trade off is an actual higher amount of capital involved in the trade and higher loss potential.

For someone not looking to risk as much capital, a bear put spread offers a way to benefit from the drop in a stocks price, while limiting cash outlay and lowering your loss exposure.  Again, not without trade offs as your overall maximum return are limited by the second leg of the trade, the short put.  I would encourage readers to play around with the options used in their bear spreads.  Here we used a long 800 and a short 750 put to create the spread, but you can use any combination of a higher put strike and shorting a lower put strike to figure out your tolerance level.

With options trading, I find it very beneficial to write out my trades and also draw out the profit and loss chart.  Visually seeing the info on paper makes it easier to conceptualize the trade.  I always like to calculate my max profit, max loss, and breakeven.  Most of my options trades are short term in nature, so while I am mostly hands off with my individual stock positions, with options it’s different.  I normally like to watch the trades play out.  If you get a trade that nets a big profit, you have to decide whether to close the trade out, or do you want to see if there are further gains to be made.  Also, in the case of spread trades, if you hit the max gain figures, I like just closing out the trade and taking my profit.

For more information on options and trades, here is something I wrote a few years ago on covered call writing using an EBAY trade, and how to hedge your portfolio or position using a protected put (this one got featured on some options site).

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