Debit/Debit Spread Strategy:
Bear Put Spread

AKA: Bear Spread

ANALOGY/METAPHOR: Buying Lottery Tickets as Part of an Office Pool

ACTION: Buy 1 at the money (ATM) put option and sell 1 out of the money (OTM) put option for the same expiration month. This is a net debit position. The premium received from the sale of the short put reduces the amount paid for the long ATM put. The maximum loss is the net debit paid if the stock price finishes at or above the strike price of the long put. The maximun gain is the difference between the two strike prices less the original net debit paid.

DESCRIPTION: The bear put spread is essentially a long put with some of the risk removed. But in exchange for this reduced risk, you're also limiting your potential profits.

By writing the second put at a lower strike price, you're doing two important things--reducing the amount of money at risk and, therefore, requiring less downward movement in the stock in order to break even or show a gain. But if the stock really tanks, you miss out on potentially huge profits.

EXAMPLE: The XYZ Zipper Company is trading around $40/share. You believe the stock will be under pressure in the near term, although you don't expect a total collapse in the share price.

You simultaneously purchase a $40 put and sell, or write, a $35 put. Both options expire in one month. You purchase the $40 put for $1.50/contract and sell, or write, the $35 put for $0.50/contract. The trade costs $100 to set up (the $150 debit less the $50 credit).

• If the stock finishes at $40 or higher, both puts expire worthless and you lose the entire $100 you had at risk.

• If the stock finishes at $39/share, you break even since the long put is $1 in the money (matching your initial investment) and the short put expires worthless.

• If the stock finishes at or below $35/share, the value of the position reaches its maximum level, $500 in this case. If the stock closes anywhere below $35/share, those additonal gains in the $40 put are offset by the increased value of the $35 short put.