• Long 1 put near the money. 
• Short 1 put deep OTM (out of the money) at a lower strike and a lower delta.

<Bear put risk graph retrieved from OptionsPlay>

A bear put spread is a bearish options strategy that buys one put and sells another put at a lower strike on the same date. This is sometimes called a debit put vertical. It is explicitly directional and wants the underlying price to move down but it also wants  IV (implied volatility) to increase as a bonus.

Opening a bear put spread can be a good strategy with a high payout if testing a Call Wall or Volatility Trigger™ from underneath, or if falling under a Put Wall.

A bear put spread is mostly a directional play. When it is right about the price dropping sharply, then it usually has a bonus from a sudden increase in IV. As another luxury, this strategy reliably has a [skew] edge when bought on index products, and on most (but not all) stocks.

Intermediate: Details

A bear put spread is sensitive to drops in IV, and will underperform if IV and spot are dropping at the same time. As a note, IV is visible in the option chain for each strike and also for the whole security on a certain date. Below, an OTM bear put spread is pictured, showing how much sharper the potential reward is compared to the max loss. The max profit of a bear put spread is the distance between put strikes minus the net debit paid. The max loss is the debit paid (the total upfront cost of the spread). 

The upside is capped at the width of the option spread minus the debit. And since OTM verticals will always have a cheaper debit than ITMs, they will always have a higher max profit since there is more premium after the debit is subtracted from the width of the spread. For example, a long OTM debit put vertical between 380 and 370 SPY has an option spread width worth 1k notionally; if the vertical has a cost of $200, then that leaves a max profit of $800 (after slippage).

Advanced: Strategic Applications

This strategy is highly popular on index products because OTM put strikes reliably have more skew (higher IV% compared to at-the-money strikes). This means that bear put spreads almost always have a skew edge on index products. And this strategy very often has this edge on stocks as well. It would be ideal to execute a bear put spread if the skew is extra high on the short leg.

One advantage of using a vertical spread is that one side can be legged-out of if the trade initially goes in the wrong direction. However, it is always much safer to leg out (close only part of a spread) of the short option since this leaves the risk defined (limited), which means that it can only lose a finite amount as if there is a logical stop loss (a max loss determined by the debit) in play, however one that will not stop the trader out.

Expert: Dynamics and Synthetics

As a bearish strategy, bear put spreads always have negative deltas. When this spread is fully OTM, gamma and vega are positive while theta is negative. And when fully ITM, gamma and vega are negative while theta is positive. An OTM play will be more aggressive and have a larger payout for a smaller chance of profit, but also a smaller max loss. An ITM approach, however, is more defensive in nature—with more durable premium but also a higher max loss and a lower max profit. 

In either case, using a vertical spread is more of a directional play than simply going long on a single leg because its premium is less vulnerable to erosion from decay in IV or time. A vertical also has a closer goalpost to breakeven since it has a smaller debit to outperform. And then a narrower debit will have an even shorter goalpost to breakeven. What this means is that a vertical is less of a race against the expected move than a long single leg option. With a vertical, there can be directional profit even if the price is moving at a slower rate than what the option market is pricing in. 

But then as a tactic, a trader can leg out of the short leg for a profit if temporarily wrong about direction (leaving only a long put). This returns some cash on the position, reduces max loss, and makes the remaining long put more explosive with uncapped profit if there is a continuation. 

A bear put spread is synthetically equivalent to a credit call vertical if swapping out the puts for calls (long put for long call and short put for short call). What this means specifically is that an OTM bear put spread is a logical match with an ITM credit call vertical.

bearish: A trade is bearish if it would profit from a decrease in the underlying (e.g. stock or future) price. Likewise, a trade thesis is bearish if it is expecting the underlying to decrease.

breakeven: The point or points where a trade is not losing any money and is on the brink of profitability. Since investment products have a bid/ask spread (sold at higher prices and bought at lower prices due to the nature of the auction process), this spread must be beaten as well to break even. Options have a wider spread than most stocks, which makes this more of a challenge. 

Call Wall: The Call Wall is the strike with the largest net call gamma. This shows us what the top of the probable trading range is (the upper bound).

debit: In an option strategy, there is a debit paid from long options or debit spreads. This is the premium paid for the opportunity to hold the position. The debit also functions as the max loss of a long option position. The counterparty receives a credit as time decay income (theta) until the option expires but takes on risks which can lead to losses and be significant if from an open-ended position. 

debit spread: In an option strategy, a debit spread is one that has a net debit (upfront cost) paid for long options. This means that there is an upfront cost which must be outperformed by expiration, however there are rights instead of obligations (which keeps the option holder in control). Unless a debit spread is deep in-the-money, it would be very unlikely for the short leg to be assigned. But if it was, then that assignment would be strongly offset by the long option leg. For out-of-the-money debit spreads, they are long gamma (accelerating directional exposure), long vega (sensitivity to implied volatility), and short theta (which means the premium gradually decays the value of the option over time). This time decay is measured by a first-order Greek known as theta.

defined risk: In an option strategy, if risk is defined then it is structured so that it has a max loss (capped total loss on a trade) rather than potentially unlimited loss.

delta: A first-order Greek that measures the sensitivity of an option's price to directional movement in the underlying security. Factoring out nonlinear dynamics, the instantaneous value of one delta is worth one share of a stock. This means that if the option on a stock is 40 delta, such as a 40 delta long call or a 40 delta short put, then instantaneously it has the same profit/loss dynamics of being long 40 shares. 

expected move: The range that the option market is pricing in for a specific period based on implied volatility. When options are more expensive, implied volatility goes up because traders are pricing in a wider implied range. The reasoning behind this is that if there is more demand to buy puts or calls, and they are still being bought despite rising prices, then the options market is pricing in a wider move that justifies paying those higher prices. The expected move can be approximated for a day if dividing implied volatility by 16 and it can be approximated for a week if dividing implied volatility by 7.2. However, at SpotGamma we provide a deep calculation for the daily and weekly expected move based on historical price patterns over decades, which is a unique and complementary approach.

gamma: A second-order Greek which compares changes in delta (directional exposure) to changes in the underlying. In general, gamma means the acceleration of directional exposure. Gamma is also one of the main properties of an option: All long options are long gamma. In a way, gamma is thought of as the magic of options because the size of directional exposure (delta) increases as it is right about direction (therefore increasing profits), and it decreases when it is wrong about direction (therefore decreasing losses). But the cost for this magic is time decay. The connection to market makers is that when they are long gamma (market gamma is positive) then they trade against the direction of the trend to lock in profits after they have favorable moves with increased size thanks to gamma. This is why positive market gamma tends to create an environment of reduced or reducing realized volatility (smaller overall price moves).

ITM (in the money): An option is in-the-money if it would still have some [intrinsic] value if the option expired with the underlying price where it currently is. Being in the money is entirely about the strike price beating the underlying price. ITM options cost more than options at or out of the money; they also have less extrinsic value. Additionally, ITM options have more deltas (immediate directional risk).

IV (implied volatility): The expected percentage range over a year with 68.3% confidence. This is based on options pricing at one standard deviation. Long options benefit from increases in implied volatility and short options benefit from decreases in implied volatility. In general, when implied volatility increases it means that the expected percentage range is getting larger. When implied volatility is applied to lengths of time other than one year, then this is called the expected move.

leg out: Legging out of a strategy is when one part of an options spread is closed before the other part(s).  For example, if one has a debit put vertical (long put and a short put at a lower strike) which loses money on a large move up in the market, then the short put can be closed for a profit. This would partially subsidize the long put and give it a chance to run without a spread if the market crashes back down. As an important point on risk management, it is always safer to leg out by closing a short option—rather than a long option—because this way the risk still remains defined (limited).

long put: To be long (buy and hold) an option contract which has limited risk and amplified potential gains from moves down in the underlying price. The max loss is the cost of the put. Going long on a put is a simple way to profit from  downside exposure to movement in an underlying security, however the underlying security (such as a stock) must outperform the premium placed on that put by the options market. In other words, a long put must beat the options market in order to profit. If closed early (well before expiration) then a long put must outpace the expected move (priced in by the options market) for a specific period of time. All long puts have long gamma and long vega but short theta. It is uncommon to exercise puts rather than simply close them for a profit, however a long put is frequently understood as a right to exercise (trade in the long put to become short 100 shares) if below the specified strike price. Synthetically, a long put becomes logically equivalent to a long call if also long 100 shares.

OTM: An option is out-of-the-money if it would have zero value expiring with the underlying at its current price. When an option is out-of-the-money, its entire price is made of extrinsic value, which is a premium that option buyers are willing to pay for an opportunity to make a profit.

Put Wall: The Put Wall is our major support level, which measures the most amount of negative gamma in the market. This shows us what the bottom of the probable trading range is (the lower bound). 

security: Any investment product that can be traded on an exchange, such as but not limited to stocks, futures, ETFs, options, bonds, mutual funds, and treasuries. 

short put: To be short (sell to open and hold) a put. Unless otherwise hedged, the owner of the short put has severe risk and only limited potential gains, which makes this an extremely dangerous strategy in isolation. If left to expire, a short put will achieve max profit if the price ends up above the strike price. Shorting a put is a way to express a thesis that one is “not bearish” such as what might be justifiably the case if testing a Put Wall from above; being “not bearish” is different than being bullish. For a short put to be profitable, the underlying security must underperform the premium placed on that put by the options market. In other words, a short put profits when the underlying security fails to beat the options market. To be closed early for a profit, there needs to be a decrease in implied volatility or the underlying must have fallen less than the options market has priced in for that specific period of time. All short puts have short gamma and short vega but long theta. Short options also come with obligations instead of rights, which means that, at any time, shares can be assigned (100 short shares for each contract); assignment usually only happens when in-the-money and near expiration). Synthetically, a short put becomes logically equivalent to a short call if the trader is also short 100 shares.

skew: Volatility skew is the difference between implied volatility amounts of different options strikes on the same date. Implied volatility is the expected percentage range over one year–based on option prices–with 68.3% confidence. Skew is one of the main edges to look for in an options trade, especially on vertical spreads (all options are on the same date). Sometimes it is a penalty dragging down a good trade, but it is nonetheless important to understand the extent of how much it can challenge a trade if knowingly accepting to take the opposite side of a skew advantage.

slippage: Losses that occur from trading as a result of commissions and differences in the bid/ask spread. 

spot: The immediate delivery price of an underlying security. Shares are always considered the spot price, while options are a derivative of that. We also referred to index prices as spot—in contrast to futures or options on them.

stop loss: In trading, a stop loss is a predefined exit point to close a trade at a max loss if the trade goes badly. Stop losses, unless otherwise specified, are market orders, which means they can transact at a worse point than expected if the underlying is moving fast or it is illiquid (lacking a high amount of buyers and sellers).

strike: The price that an option is based on. A long call will expire worthless if the price of the underlying security finishes underneath the strike price, and a long put will expire worthless if the underlying finishes above the strike price.

synthetics: In options, synthetics are different structures that have the same logical dynamics, including the same max loss, max profit, chance of winning, and option Greeks. Synthetics are possible because options have the property of put-call parity. For spreads, long puts can be swapped for long calls and short puts can be swapped for short calls (and vice versa) in a way that creates synthetic matches without the need of adjusting deltas with shares. On single-leg options, however, puts and calls can be swapped in the same way, but require directionally-offsetting positions in the underlying security (such as a certain amount of shares).

theta: The measurement of how much an option's price changes relative to time. Often used to mean time decay, theta gets stronger in an accelerated fashion as the time of an option runs out. If long an option, then time decay causes net losses (unless more is earned from increases in implied volatility or sharp and favorable price movements). And if short an option, then time decay causes net profits (unless more is lost from increases in implied volatility or sharp and unfavorable price movements).

underlying: A reference to the immediate price of the underlying security. This is also sometimes called spot (the spot price of the underlying). The spot price is in contrast to derivatives which have option prices or [forward] futures prices.

vega: A first-order Greek which measures the sensitivity of an option to changes in implied volatility (the expected percentage range based on option prices with 68.3% confidence). When we say extrinsic value, this pertains directly to vega and theta (the sensitivity of an option to time decay). As options run out of time on the contract, vega decreases. This is why we often see short duration options with very high implied volatility amounts: the higher implied volatility is balanced out by a smaller slice of vega, which is the influence of implied volatility on the price of an option.

vertical spread: Any option strategy which has all contracts expiring on the same date. In contrast to a horizontal spread (calendar) or diagonal spread (combination of vertical and horizontal strikes), vertical spreads are usually the most directional and also the easiest to manage. With vertical strategies, the main edge at play is usually skew (differences in implied volatility for different strikes on the same date). Implied volatility is the expected percentage range over the next year—based on option prices—with 68.3% confidence.

VT (Volatility Trigger™): The VT is our proprietary indicator which detects the level below which we expect bearish feedback loops (chain reactions) to start kicking in. Above this level we expect bullish flows that lead to relatively lower market volatility. Underneath the VT, realized volatility (the expected percentage range over a period of time based on historical data with 68.3% confidence) is modeled to expand significantly. In the Equity Hub™, a similar calculation is used for what is called the Hedge Wall. 

width of the option spread: The width of the spread is a key mechanic when designing an option strategy to make a trade. In a vertical spread (both options are on the same date), the width is the difference in strikes. For a horizontal spread, both options are on the same strike but a different date). The width of the spread on horizontal spreads is the time width, which is the difference in DTE (days to expiration) between both sides of the spread.