Introduction
A bear spread is a widely accepted strategy in stock trading for limiting risk when an investor expects the price of a stock or index to decline. In this article, you will get a detailed understanding of bear spreads and their workings, the advantages of this approach—and when these spreads are most useful.
What is a bear spread?
Bear spread is an options trading strategy that allows the realization of profits on an asset’s decline. Under it, options of the same type (that is, either calls or puts) are bought and sold with different strike prices but the same expiration date.
- A put option is purchased at a higher strike price, and a put option is sold at a lower strike price.
- This entails that the trader expects a very rapid fall in the stock price.
- Profitability: Limited to the difference between the strike prices minus the net premium paid.
- Risk: Limited to the net premiums paid.
How Does a Bear Spread Work? (Nifty Example)
Let’s consider an example using Nifty options:
- Assume Nifty is currently at 22,860.
- You expect Nifty to fall, so you create a Bear Put Spread.
- You buy a 23,000 put option by paying Rs. 150 per lot.
- You sell a 22,700 put option and receive Rs. 80 per lot.
- Total cost = Rs. 150 – Rs. 80 = Rs. 70 per lot.
- If Nifty falls to 22,700 or below, you make a profit.
Risk-Reward Calculation (Considering Lot Size of 75)
- Maximum Profit: (Higher Strike Price – Lower Strike Price) – Net Premium Paid
= (23,000 – 22,700) – Rs. 70
= 300 – 70
= Rs. 230 per lot.
Total Maximum Profit: 230 × 75 = Rs. 17,250
- Maximum Loss: Net Premium Paid
= Rs. 70 per lot.
Total Maximum Loss: 70 × 75 = Rs. 5,250
- Break-Even Point (BEP): Higher Strike Price – Net Premium Paid
= 23,000 – 70
= 22,930.
So, on any closure of Nifty below 22,930, you begin to profit. On the contrary, the days the nifty stays above 22,930 will still make you incur a loss to a maximum of Rs. 5,250 per lot.
Advantages of the Bear Spread
Controlled Risk: Owing to both parameters of options being involved, the loss has a cap.
Lower Margin: It requires less capital than short selling.
Guards Some Profit: This is used in a situation where the market declines or stabilizes.
Suitable for Slight-to-Moderate Bearish Views: This is made for traders who expect some small or moderate decline, not one enormous crash.
When To Apply The Bear Spread?
Bearish Market Environment: Whenever you suspect there is going to be some moderate decline in stock or index price.
Hedging Approach: To safeguard existing investments against prospective downside risks.
Limited Availability of Funds: If you don’t want to risk too much money but, at the same time, want to take advantage of falling prices.
Conclusion
An overview of the strategy presents the Bear Spread as an intelligent and strategic method to profit from an appreciated stock market with limited risk. Traders can effectively take advantage of bearish stock market conditions by either selling options in a bear call spread or buying options in a bear put spread. Understanding how the strategy works and when to appropriately apply it will help traders make informed decisions about their investments.