Exactly what is the difference between bear put spreads and bear call spreads, for example? Do you really understand why they are each called by that name? This article is a look at getting our options trading terminology correct.
Here’s the way it works.
The first word in the phrase signifies your opinion of the market. So a bear put spread would indicate that you are of the opinion the underlying stock under consideration is getting ready to take a price dive. In other words, you’re bearish about the stock, which means your vertical spread strategy will exhibit that.
The subsequent part of the term implies not merely the type of spread you are going to do, but when combined with the bearish nature of your view of the stock, the fact that it will be a debit spread (not a credit spread). Should you be doing a credit spread, you would want the underlying to stay away from the spread strike prices until option expiry date for it to be profitable. But for a debit spread you’d ideally want it to penetrate through both strike prices for maximum profit.
Bear put spreads are option debit spreads that are structured by buying put options with a strike (exercise) price that is near the current market price of the share … and at the same time selling the exact same number of put options at an exercise price which is lower than the bought options. Since the bought options will be more high priced (being closer to the money) than the sold ones, the net result is a debit to your brokerage account – consequently, the "debit spread" aspect of the trade.
Since we get into put debit spreads because we believe we could make considerable gain in the event the underlying price falls, they provide an opportunity of entering a greater number of option positions at less cost than simply buying (going long) puts. They furthermore allow increased flexibility should the underlying price temporarily go against us, for the reason that we can contemplate buying back the ‘sold’ position at a fraction of what we sold it, in the hope that should the stock return to its downward trend, we will profit from the remaining bought put option, which we now own at a tremendous discount.
Bear Put Spreads need to be distinguished from bear call spreads. Bear Call Spreads are credit spreads, again the result of a bearish view of the market but comprised of call options (not put options) in the hope that the underlying stock will remain away from their strike prices.