There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying asset at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
Let's look at a bear put spread.
The basic setup
The way that you construct a bull put spread is to buy a higher strike price put, and then sell a lower strike price put. The goal is to have the stock decline in price and close upon expiration at a price less than or equal to the lower strike. A vertical spread will have two strike prices with the same expiration month. Since the put contract with the lower strike price will be worth less than the call contract with the higher strike price, the net result of this transaction will be a net debit.
As an example, let's say that a stock is currently trading at $50. A $40 put is priced at $4, and a $30 put is priced at $1. Buying the $40 put while simultaneously selling the $30 put would result in a net debit of $3. Let's work through the position's maximum loss, maximum gain, and breakeven point.
Max loss: net debit
The most that you can lose on any debit spread like a bear put spread is simply the amount that you paid for it -- the net debit. The max loss occurs if the stock closes upon expiration at any point higher than the higher strike price. All contracts would expire completely worthless with zero value.
In this example, the max loss would be $3, which would occur if the stock closed upon expiration above $40.
Max gain: Difference in strike prices minus net debit
The most that you can make on a bear put spread is the difference in strike prices less the amount paid. Since a bear put spread has a predefined difference between the strike prices, the max gain occurs if the stock closes upon expiration at any point lower than or equal to the lower strike price. If that occurs, then technically you exercise the put to sell the stock at the higher strike, while the other put is automatically exercised if it's in the money and you would purchase the stock at the lower strike. But then you must subtract the upfront cost of the trade.
In this example, the max gain would be $7, which would occur if the stock closed upon expiration less than or equal to $30. You would purchase the stock at $30, sell it at $40, but subtract out the $3 in premium that you paid.
Breakeven: higher strike minus net debit
In order to breakeven on this trade, the stock must close upon expiration at a price equal to the higher strike minus the net debit of the trade. The higher strike put must be in the money upon expiration in order for the higher strike put to have any value, but you would need to recoup the upfront cost in order to breakeven. The higher strike put's value would be equal to the net debit, while the lower strike put expires worthless.
In this example, the breakeven would be $37. The $40 call would be worth exactly $3, equal to the initial premium paid, while the $30 call would expire worthless.
No margin requirements
While some options positions have margin requirements associated with them, debit spreads generally do not. That's because your risk is very clearly defined as the upfront cost. The worst thing that can happen is that all contracts expire worthless. Neither you nor your broker/dealer is exposed to potential losses beyond this amount. This makes the position simpler to manage and monitor, since you don't need to worry as much about margin calls or other margin equity requirements.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.