Bear Put Spread concept explanation
If the prices of houses in a particular area have risen a lot in the past month and you think that they will fall in the current month you can utilize a bear put spread.
Technical explanation, we will simplify it right after this:
A bear put spread is a type of options strategy where an investor or trader expects a moderate decline in the price ofa security or asset. A bear put spread is achieved by purchasing put options while also selling the same number of puts on the same asset with the same expiration date at a lower strike price.
The maximum profit using this strategy is equal to the difference between the two strike prices, minus the net cost of the options.
Source: Investopedia
Understandable explanation:
- We expect the house prices in an area to go down.
- The house prices are printed in the newspaper.
- An insurance company is offering insurance on the house price even if you don’t own it. Read about Insurance(Put option)
- Since we expect the price to go down we can pay a insurance premium to the company and get insurance for the house price going down.
- We pay the premium and now if prices go down the insurance company will pay us.
Let us make some assumptions:
- Current price of the house: 1,000
- Insured amount: 900
- Premium for insurance: 10paid by you to the company.
The house owner also wants to get insurance for an insured sum of 800, you decide to offer them this insurance.
House owner insurance:
- Insured amount: 800
- Premium for insurance: 5(paid to you by the house owner.)
The validity of these insurances has to be the same. Let us assume 30 days.
We have now setup a Bear Put spread.
What happens at the end of the month:
(i.e. the 30 days when insurance for both you and the house owner runs out)
| House Price (Share Price) |
Our Insured Price | Premium Paid (by us) |
House Owner Insured Price | Premium Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,000 | 900 | 10 | 800 | 5 | -5 | |
| Price of house at the end of the month | If price goes below this price the
Insurance company will pay us the difference. |
Insurance premium paid by us to Insurance company | If price goes below this price
we have to pay the house owner the difference. |
Insurance premium received by us. | The insurance premium is kept by the insurance company. It will be considered a loss.
We keep the insurance premium from house owner. Premium Received – Premium Paid = 5 – 10 = -5 |
|
| House Price (Share Price) |
Our Insured Price | Premium Paid (by us) |
House Owner Insured Price | Premium Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 850 | 900 | 10 | 800 | 5 | +45 | |
| Price of house at the end of the month | If price goes below this price the
Insurance company will pay us the difference. |
Insurance premium paid by us to Insurance company | If price goes below this price
we have to pay the house owner the difference. |
Insurance premium received by us. | Price is below our insured price, Insurance company pays us:
Insured Price – Month End Price = 900 – 850 = +50 Price is above house owner insurance price, we keep the insurance premium from house owner: +5 Total Profit = Premium Received – Premium Paid + Payout from Insurance Company 5 – 10 + 50 = +45 |
|
| House Price (Share Price) |
Our Insured Price | Premium Paid (by us) |
House Owner Insured Price | Premium Received (by us) |
Profit/Loss | |
|---|---|---|---|---|---|---|
| 500 | 900 | 10 | 800 | 5 | +95 | |
| Price of house at the end of the month | If price goes below this price the
Insurance company will pay us the difference. |
Insurance premium paid by us to Insurance company | If price goes below this price
we have to pay the house owner the difference. |
Insurance premium received by us. | Price is below our insured price, Insurance company pays us:
Insured Price – Month End Price = 900 – 850 = +50 Price is below house owner insurance price, we have to pay the house owner: House Owner Insured Price – Month End Price = 800 – 500 = 300 Total Profit = Premium Received – Premium Paid + Payout from Insurance Company – Payout to House owner 5 – 10 + 400 – 300 = +95 |
|
You can now see why it is less risky to take a Bear Put spread when you think any asset(house, shares) prices will fall.
The above scenario is only for demonstration, the changes of finding such a high risk reward ratio are extremely low.
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All information here is for educational/research purposes only, we do not recommend trading.