Bear Put Spread: Woolworths Limited (WOW) Past Recommendation

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This is a past recommendation that demonstrates how a bear put spread is implemented in real life.

Trade:

Bear Put Spread

Sell 2 WOWB7 Sep 08 2200 Puts @ 55

Buy 2 WOWW3 Sep 08 2550 Puts @ 175

Net Cost = 120 cents

This trade requires no margin requirements.

Maximum Profit

The ideal result is for the share price to fall below the lower strike price of $22.00.

= Difference between strike prices less net premium received

= 3.50 – 1.20

= 2.30 x 2 contracts

= $4,600

Maximum Loss

This will occur if the share price is above the bought at expiry

= Net Premium Paid

= 1.20 * 2 contracts

= $2,400

Breakeven

Higher strike minus net premium received

= 25.50 – 1.20

= $24.30

Main Benefits of Strategy

1. Provides leveraged exposure to a decrease in the share price

2. The ideal result is for the share price to fall below the lower strike price of $22.00.

Risk:

The main risk is for the share price to increase above profitable range ($25.50) and stay there until expiry. If the position expires above the high strike, the position will expire worthless and there will be no exit cost to the trade. If it is below, we will have to exit the trade to avoid being exercised. A change in volatility levels can also have an effect on the profitability before expiry, however the max loss and profit is known at expiry. Contact your adviser for more information.

Technical Analysis

WOW has a large bearish head and shoulders pattern which has taken about a year and a half to develop. These patterns are usually very reliable and the stock has broken below the neck line this morning. The head and shoulders give a price target of $17.00. We are trading a bear put spread out to September which will return around 200% if the stock falls to $22.00 which is realistic considering the price target for this pattern is $17.00. The September position gives just over 3 months for the stock to fall. Due to the break today, the volatility on the out of the money puts options are very high, so this trade is actually been filled for below fair value which of course is in our favour.


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Bear Put Spread: Bear Put Spread vs. Bought Put Option

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There are a number of advantaged of implementing the bear put spread instead of buying a put option. A bear put spread has lower risk than strictly buying put options, but limited profit potential. The bear put spread also has a higher breakeven so the share price does not have to fall as far as a bought put option. The advantages of a bear put spread over a bought put is that the strategy reduces time decay and volatility influence on the strategy pricing. This is because we are selling the out-of-the-money options therefore that option benefits from time decay and volatility reducing the opposite characteristic to a bought call option. Bear put spread can be used when volatility is high and buying a put is too expensive as it eliminates the risk of volatility decreasing. Another reason to trade bear puts is that you might have identified a support level; you can sell the out-of-the-money options at that level to reduce the cost and that will be the maximum profit level at expiry. The main benefit to just buying options is large potential profits and a better delta meaning easier to exit the trade earlier. Also if you are expecting volatility to increase significantly a bought positions will improve as a bear put spread would not.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Strategy Risks

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It is important to always be aware of the strategy risks. The main risk to be aware when trading bear put spreads is there is a potential to lose all of money invested. Time decay is a risk if the share price stays still as the sold put option does not totally eliminate the risk of time decay. Also if the share price move happens too quickly the bear put spread may only have a small profit because the volatility would have increased in the out-of-the-money option, meaning it would be expensive to buy back to close out the trade.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Trade Analysis – Risk vs. Reward

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Trade Analysis

Analysing your trade is essential before placing the trade. You need to max sure you have the necessary detail and go through the following checklist:

1. Stock Selection: Double check your analysis on the stock and make sure you share price target for the bear put spread is realistic.

2. Determine entry cost, most important as it is also your maximum loss.

3. Determine max profit and check that it is realistic.

4. Make sure you have a good risk vs. reward.

Risk vs. Reward

The risk vs. reward of a trade should be calculated before placing the trade. A bear put spread should have a relatively high risk vs. reward as you need a fall in share price to attain maximum profit. A bear put spread should have a risk vs. reward of 1:1.5 or greater. You should aim for a risk reward around 1:2. This means that you need to have a 33% success rate to be a successful trader. It also helps with your risk management by allocating a risk level per trade and a maximum profit level to take profits.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Technical and Fundamental Analysis

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Technical Analysis

Identifying bear put spreads can be assisted through technical analysis. Technical analysis allows identification of expected price movement through indentifying trends through momentum indicators and trend lines. Technical indicators used to identify bear put spreads include:

  • Share Price Downtrend
  • Overbought – MACD and Stochastic
  • Momentum indicators
  • Breaks below support

Fundamental Analysis

Fundamental analysis can determine if a trade is viable or not. There are a number of fundamental factors that influence the option prices of a stock. When identifying a bear put spread you have a bearish outlook on the share. Therefore you are looking for negative news in the company or sector. This may be a worst then expected profit announcement or a global affect on a specific sector or industry.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Identifying Trades – The Greeks

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Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bear put spread. The net delta is calculated by the delta of the bought put option minus the delta of the sold put option. The net delta of a bear put spread is always negative. The net delta indicates if the share price decreases quickly what the value of the bear put spread will be worth. For example, if a bear put spread had a net delta of -0.30, and the share price decreased by $2.00, the bear put spread would have increased by 60 cents.

Vega

The volatility affect on a bear put spread is varied. When looking to enter a bear put spread you look to buy an at-the-money put option. The idea is to buy a put which has a relatively low volatility and therefore trading at its theoretical value. The sold put is sold out-of-the-money and the aim to sell puts with higher volatility so you receive a larger premium. The strategy can be traded with high volatility as the volatility does not affect this trade as much as buying a put option. This is because the high volatility is priced into both the bought and sold call options.

Theta

The effect of time decay on this strategy varies with the underlying stock’s price level in relation to the strike prices of the bought and sold options. If the stock price is midway between the strike prices, the effect can be minimal. If the share price is closer to the higher strike price of the bought put, losses generally increase at a faster rate as time passes. Alternatively, if the share price is closer to the lower strike price of the sold put, profits generally increase at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Option Pay-Off Diagrams

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It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and breakeven level at expiry. The bear put spread is made up of a bought put option and a sold put option at a lower strike. When combined it creates a bear put spread. See below for how the bear put option pay-off diagram is constructed. The dotted green line is the sold put and the dashed green line represents the bought put.

Sold Put


Bought Put


Bear Put Spread


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Bear Put Spread: The Psychology

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The psychology or reasoning behind placing a bear put spread is determined by the expected share price move and analysis of “The Greeks” and how they affect the option prices.

The expected share price movement is bearish meaning your view is the share price will decrease. This means you would buy a put option to take advantage of a fall in the share price, however because you are selling an out-of-the-money put to receive a premium there is limited profit potential. The reasons for doing this are;

  • A premium is received and it lower your entry cost.
  • Share price outlook may be a bearish share price decrease towards a support level.
  • Also consider the bear put spread when you are expecting a limited fall in the price of the share.
  • Just buying a straight put may be too expensive so selling an option against it may make the option trade affordable.
  • A bear put spread has a higher breakeven price than just buying a put.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: Advantages vs. Disadvantages

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Advantages of Bear Put Spread

  • The loss is limited if the share price rises instead of fall.
  • If the share price fails to fall beyond the strike price of the out-of-the-money sold put option, the profit yield will be greater than just buying put options.
  • It is also a way of buying put options at a discount by selling the out of the money put option at a strike price beyond that which the underlying asset is expected to fall.
  • The breakeven on the bear put spread is higher than just buying a put.

Disadvantages of Bear Put Spread

  • There will be no more profits possible if the share price falls beyond the strike price of the out-of-the-money put option so profit is limited.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Put Spread: The Strategy

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A bear put spread is a moderately bearish option strategy that profits when the underlying share price falls. A bear put spread is the reverse of a bull call spread and works the same way but profits from a fall in the share price rather than an increase in share price. The bear put spread involves simultaneously buying a put option at a strike price while also selling the same number of put options of the same stock but at a lower strike. A bear put spread is also a technique to buy put options at a discount. Because you sell an out-of-the-money put option in this option strategy, it effectively reduces your investment on your bought put options. This reduces upfront payment and therefore the risk of the position.

Maximum Profit

Maximum profit is achieved when the share price falls below the sold put at expiry. The maximum profit in this strategy is the difference between the strike prices of the long and short options, less the net cost of options.

Maximum Loss

If the stock price increases above the bought put at the expiration date, then the investor has a maximum loss potential of the net debit. The net debit is the premium received for selling the out-of-the-money put minus the cost associated to purchase the put option.

Break Even

The breakeven is higher than just buying a put which means the share does not have to fall as far. The breakeven point is the strike price of the bought put minus the net debit paid.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au