Bear Put Spreads: An Alternative to Short Selling

In this article, we will discuss

• Short Selling and Its Limitations
• Buying a Put Option
• The Issue With Buying Puts
• Bear Put Spreads: A More Effective Alternative
• Quantifying the Benefits of the Bear Put Spread
• Bear Put Spread Made Easy with Options B.R.O.
• Conclusion

When you begin trading in the stock market, your strategies may be focused on profiting from upward price movements. Most beginners are trained to assume that rising markets are a good sign while falling markets are unfavourable. However, with the right trading strategies and by choosing a suitable segment like the derivatives market, you can also benefit from bearish moves. Of course, you also need the right tools. Samco’s advanced options strategy builder, aptly named Options B.R.O, can be a revolutionary addition to your F&O trading plan.

Designed to sort through and analyse thousands of options trading strategies, Options B.R.O gives you the top 3 strategies for your market outlook within seconds. You can zero in on the best strategies for bullish, bearish, neutral and volatile markets with just a few clicks.

This feature can help you make the most of a falling market too, because you no longer need to rely on the traditional method of short selling. Instead, you can implement more effective strategies like bear put spreads. Want to know why the latter is a better alternative to simple short selling? Let us delve into the details.

Short Selling and Its Limitations

In a falling market, you may naturally gravitate towards a short position. For instance, if you expect the price of a stock to fall, you may initiate a short trade in that stock, so you can sell high and buy low. However, the main problem with this strategy is that short selling in the equity segment is only allowed for intraday trades.

This essentially means that you cannot hold your short positions overnight and must square them off during the day’s trading session. Unfortunately, bear markets may occur over multiple trading sessions. So, direct short selling is ineffective if you want to leverage such price movements.

Buying a Put Option

The options market offers a better alternative to short selling with the put option. This is a derivative contract that gives the buyer the right (but not the necessity) to sell the underlying asset at the specified strike price at expiry. This automatically extends the duration over which you can potentially profit from a bearish market.

The window of opportunity remains open till the expiry date, which may range from 1 to 3 months (depending on whether you purchase a near-month, next-month or far-month put option).

For example, say you expect a company’s stock to decline in the near future. So, you decide to purchase a put option on this stock to profit from the price decline. Suppose that the company’s share price is currently Rs. 1,157 and you expect it to decline because of poor sectoral prognosis in the coming weeks. So, you decide to buy a put option whose strike price is Rs. 1,160 for a premium of Rs. 20 per share.

This means that if the lot size of the contract is 100 shares, you pay Rs. 2,000 at the outset (i.e. Rs. 20 x 100 shares). Thereafter, you monitor the market and wait for the outcome. If the share price falls as expected, say to Rs. 1,130, you can sell the 100 shares at Rs. 1,160 each and buy them back cheaper, earning Rs. 30 per share or Rs. 3,000 in total. Setting this off against the premium paid, you have a net profit of Rs. 1,000 (i.e. Rs. 3,000 — Rs. 2,000).

The Issue With Buying Puts

At first glance, buying a put naked may seem like an effective strategy in a bearish market. However, it has certain limitations too, as outlined below:

• High Upfront Cost:

Since buying a put is not hedged in any way, the cost of the trade is not minimised by any opposing position. This may lead to a high upfront cost for traders on a tight budget. A better alternative would be to hedge this trade.

• Large Price Movement Required:

Buying a put is only profitable if the price drops significantly. In our example, the price has to drop below Rs. 1,140 (i.e. the strike price minus the premium) for you to start earning profits.

Bear Put Spreads: A More Effective Alternative

Bear put spreads can be more effective if you expect smaller price declines and if you want to reduce the upfront cost of your trade. This trade involves buying a put with a higher strike (ATM strike) price and selling a put with a lower strike price (OTM Strike). The premium earned from the short put helps offset the cost of the long put to a certain extent.

Consider the same scenario discussed earlier, where a company’s share price is currently Rs. 1,157 and you expect it to decline slightly. So, you decide to execute the bear put spread strategy, which involves the following trades:

• Trade 1: A Long Put

Here, you purchase a put option whose strike price is Rs. 1,160 and pay a premium of Rs. 20 per share.

• Trade 2: A Short Put

Here, you sell a put option whose strike price is Rs. 1,150 and earn a premium of Rs. 15 per share.

So, the net debit at the outset is Rs. 5 per share (i.e. Rs. 20 — Rs. 15). If the lot size is 100, the net opening debit becomes Rs. 500. Now, let us analyse the different possible outcomes, where the share price either rises or falls at expiry.

Quantifying the Benefits of the Bear Put Spread

The bear put spread strategy has two key advantages in a bear market over naked long puts. It reduces the initial cost of the trade and it increases the break-even point, making the position profitable even for smaller price declines. In the above example, we can quantify these benefits as follows:

• Reduced Cost of Trading

The use of a short put to hedge the long put brings down the total cost of the trade because you earn a premium on the option sold. The overall cost of your trade has been reduced by 75%, from just buying a put for Rs. 2,000 to setting up the bear put spread strategy for just Rs. 500.

• Improved Profitability

The profitable region also expands because the breakeven point rises from Rs. 1,140 to Rs.1,155 (i.e. Rs. 1,160 — Rs. 5). So, even a price dip of just more than Rs. 2 (from the current price of Rs. 1,157) could be profitable for you if you opt for the bear put spread strategy instead of a simple long put.

Bear Put Spread Made Easy with Options B.R.O.

It can be incredibly challenging to manually determine the ideal time to implement the bear put option spread strategy and decide the optimal entry point, stop-loss limit and take-profit level. However, with Samco’s Options B.R.O., you can easily identify if the bear put spread strategy is suitable, analyse the strategy thoroughly and also implement it instantly from the Samco trading app itself.

Here is a handy guide to help you with this.

• Step 1: Identify a Bearish Stock

You need to first identify a stock that you expect will be moderately bearish at expiry. This is crucial to find the bear put spread in Options B.R.O as the strategy is tailored for markets with moderate price declines.

• Step 2: Submit the Inputs Required on Options B.R.O

Select the scrip, choose its expiry and submit your view on the stock as per your analysis. For instance, say you are bearish on Bank of Baroda’s stock. Here is what your Options B.R.O inputs may look like:

• Step 3: View the Top Strategies Suggested

After you submit your inputs, Options B.R.O in the Samco trading app scans suitable strategies, eliminates illiquid contracts, evaluates options Greeks and optimises risk and reward. Then, it suggests the top strategies for your market outlook. In addition to this, you can also view hundreds of other suitable strategies.

• Step 4: Find and Analyse the Bear Put Spread

Once you find the bear put spread strategy, you can analyse various aspects of this trade like the probability of profit, estimated margin, maximum profit and loss, and the strategy legs. You can also view the profit and loss graph from this trade on different dates — right up to expiry. Options B.R.O in the Samco trading app also shows you the payoff details and the strategy Greeks, so you can make an informed decision about the bear put spread trade.

• Step 5: Execute the Trade with a Few Clicks

After analysing the strategy and familiarising yourself with the outcomes, you can make a more informed decision about whether or not it aligns with your risk-reward preferences. If it does, you can customise the order as needed and execute it with just one click. It’s that simple!

Conclusion

This sums up all you need to know about the bear put spread. While they can be quite profitable in the right markets, you should also understand that the profit potential in this strategy is capped. If this aspect of the strategy is suitable for your risk-reward expectations, you can analyse the bear put spread on the Samco trading app and execute it instantly if the market outlook is favourable.

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