Who Should Consider Buying SPX Put Spreads?
- An investor who is moderately bearish on the Standard & Poor’s 500 index (SPX) and wants to profit from a decrease in its level
- An investor who wants to reduce the cost of buying an SPX put in return for limited downside profit potential
- An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk
A bear put spread is one four types of vertical spreads, all of which are characterized by both limited profit as well as limited loss potential. This spread allows an investor the opportunity to profit to a limited extent from a limited move in the level of the SPX, while having less capital at risk than with the outright purchase of a put option.
An SPX bear put spread involves the purchase of an SPX put, and the simultaneous sale of another SPX put with the same expiration month but with a lower strike price. Both of these transactions open a position. That is, the investor is at the same time making an opening purchase (and becomes long) the higher-strike put and an opening sale of (and becomes short) the lower-strike put. Because the long, higher-strike SPX put that is being purchased will always cost more than the premium received from the lower-strike put’s sale, the bear put spread is termed a debit spread. An investor will always pay a net debit, or will buy (and become long) the spread to establish one.
The long, purchased put provides the bearish opportunity to profit on the SPX’s downside. By selling the lower-strike short put, the investor receives premium with two results. First, this premium, which the investor keeps, will reduce the net cost of the purchased long put. But second, as a trade-off the short put will cap that long put’s downside profit potential because of the likelihood of assignment if the SPX index is below the short put’s strike price at expiration.
To close out this long bear put spread position before expiration, an investor may sell the spread, or simultaneously sell the higher-strike long put (if it has value) and buy back the lower-strike short put, taking in a net premium amount, or a net credit. By doing so an investor can either realize a net profit on the long spread or cut a loss. Bear put spreads are commonly established (purchased) and closed out (sold) as a package, i.e., the two options bought and sold in one transaction.
The maximum, downside profit for the SPX bear put spread is limited, and will generally occur at expiration when the SPX settles at or below the short put’s strike price. At this point, the long put will be worth its intrinsic value (cash settlement amount), but if the short put expires in-the-money the investor can expect assignment and have to pay its cash settlement amount. The maximum profit amount can be calculated in advance as the difference between the two put strike prices, less the total premium initially paid for the spread, times the $100 multiplier.
On the upside, however, the financial risk is limited to the total premium paid for the spread, no matter how high the SPX increases, and both the long and the short puts expire with no value. This will occur if SPX settles at or above the long put (higher) strike price. The break-even point at expiration is an SPX index level equal to the higher (long) put strike minus the premium paid for the spread. The effect of volatility and time decay on this strategy varies depending on whether the options are in- or out-of-the-money and the time remaining until expiration.
NOTE: SPX options are European-style; they may not be exercised until the last business day before expiration, or the day following their last trading day. Assignment, therefore, cannot be received until expiration.