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Rishi is an amateur investor, while his friend Ishita has been active in the securities market for a long time. This is what happened during their friendly chat:
Rishi: The market has become bearish and wiped out almost all of my profits. I have no immediate liquidity when I need some profits.
Ishita: This happens when you only invest in stocks. As the market is volatile, you never know when the prices can fall.
Rishi: In a time like this, what do you do? How do you keep your portfolio healthy and realize profits? What do experienced investors do?
Ishita: Most of them look towards derivative trading, which includes buying or selling futures or options contracts.
Rishi: Derivatives trading?
Ishita: Yes, within derivatives trading, most investors prefer options trading as it does not force them to buy/sell the contract if they do not want to. Such contracts give them the right but not the obligation to sell the contract, allowing them to cut the risk of losses significantly. Another way to trade in options is through a strategy called Bear Put Spread which I am using right now.
But before you dive into how you can make profits through a bear put spread strategy, you must understand a little about options trading and related terms.
An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without having to buy/sell the contract.
A call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties.
A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the price on the date agreed upon by the contracting parties.
Before you jump to understand bear put spread, it is crucial to understand the following terms:
Strike Price: The price at which the options contract was initially bought or the pre-determined price.
Spot Price :The current price of the underlying asset attached with the put option contract.
Premium: It is the price you pay to the seller of the option for entering into the online trading options.
In-The-Money (ITM) call option: When the underlying asset price is higher than the strike price.
Out-of-the-money (OTM) call option: When the underlying asset price is lower than the strike price.
The bear put spread strategy or bear put spread is when an investor sells a put option while simultaneously buying another put option with the same underlying asset and the expiration date.
Unlike a bear call spread where the investor makes profits through the premium amount, a bear put spread demands the investor pay a higher premium and receive a lesser amount. Hence, there is a net debit in premium. However, it is not the premium amount from which an investor makes a profit in a bear put spread. The investors make profits through the difference in the strike prices of the two put options minus the net premium.
Investors use the bear put spread strategy when they believe that the market is bearish and the price of the underlying asset will go down moderately in a short period. The bear put spread strategy is also known as a bear put debit spread.
It is almost the same as a bear call spread example. However, unlike a bear call spread, here there will be a net debit in the premium amount, and the maximum profit is the difference between the two strike prices of put options.
Here is an extended example to understand bear put spread:
Consider a company called XYZ, whose stock is trading at Rs 58. If you think that the price of the stock of XYZ will go down in a few days, you can initiate a bear put spread on the company. The following is the information about its options contract and the premium:
The Lot size is 100 shares.
An investor initiating a bear call spread can do the following transaction:
Net Loss: Rs -200 (100-300)
Now, the three possible scenarios can arise in the bear call strategy:
Scenario 1: The stock price remains unchanged at Rs 58
Scenario 2: Stock price goes up to Rs 62
Scenario 3: The stock price falls to Rs 54
The 300 is the total profit earned due to the difference in the strike price minus the premium paid.
Here are the advantages and disadvantages of a bear put spread:
Similar to a bear call spread, a bear put spread also allows investors to bet against the falling market and make a profit. If you are well-versed with the bear put spread strategy, it can prove to be an effective technique to multiply wealth and mitigate the chances of losses. If you are interested in options trading, you can visit the IIFL’s website to open a free Demat and trading account. You can also download IIFL’s Share Markets app from the app store to open the accounts.
Now that you know what is bear put spread and bear put spread definition, you can go ahead and utilize the effective strategy.Checkout the PCR ratio to know the number of put options and call options traded in a day.
Here is how you can calculate your bear call spread:
Maximum Loss: Net premium paid + Commissions Paid
Maximum Profit: Difference between call options strike prices – net debit premium + commissions paid.
No profit/no loss: Strike price of the long put option – Net premium
As both of the bear call spread and bear put spread rely on a bearish market outlook, an investor can choose any of them based on his niche and past experience. You can contact a financial advisor such as IIFL to make informed decisions and choose an ideal strategy.
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