Thursday, December 27, 2007

The bearish put spread

Initiating a bear put spread involves the buying of a put option on an underlying stock, while at the same time writing a put option on the same underlying stock and expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly called as a "vertical spread". A family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be made with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "all or nothing" in one single transaction, not as separate transactions. For this bearish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. Brokerages which specialize in options would be best for this.

An investor often employs the bear put spread in moderately bearish market market conditions, and wants to capitalize on a minimul decrease in price of the underlying stock. If the investor's opinion is very bearish it will generally prove more profitable to make a simple put purchase.
An investor will also turn to this spread when there is uneaseiness with either the cost of purchasing and keeping the long put alone, or with the confidence of his bearish market opinion.

The bear put spread can be thought of as doubly hedged strategy. The cost for the put with the higher strike price is partially offset by the money received from writing the put with a lower strike price. Therfore, the investor's investment in the long put and the risk of losing the entire premium paid for it, is reduced or hedged.