Limited Participation in an Decreasing SPX Index Level with Limited Upside Risk
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor is moderately bearish on SPX index over the next couple of months, with the SPX currently at 1398, and decides to establish an SPX 1400/1395 bear put spread. He purchases one two-month SPX 1400 put for a price of $27.25, and at the same time sells (writes) one two-month SPX 1395 put and receives $24.90 The total net debit for the spread is $27.25 $24.90 = $2.35 x $100 contract multiplier = $235.00.
By purchasing the bear put spread the investor is saying that by expiration he anticipates the SPX index to have declined moderately to a level below the break-even point (BEP): $1400 strike price $2.35 (the net debit paid), or an SPX level of 1397.65. The investor’s maximum profit potential is limited: 1400 (higher strike) 1395 (lower strike) = $5.00 - $2.35 (net debit paid) = $2.65 x $100 multiplier = $265 total. This profit would be seen no matter how low SPX index has declined by expiration. The upside risk for the bear put spread purchase is limited entirely to the total $235 premium paid for the spread no matter how high the SPX index increases.
Before expiration, if the put spread purchase becomes profitable the investor is free to sell the spread in the marketplace to realize this gain. On the other hand, if the investor’s moderately bearish outlook proves incorrect and the SPX index increases in price, the put spread might be sold to realize a loss less than the maximum.
Buy 1 SPX 1400/1395 Put Spread at $2.35 Debit
Consider three possible scenarios at expiration:
- SPX exercise settlement value at or below the lower strike price
- SPX exercise settlement value between the strike prices
- SPX exercise settlement value at or above the higher strike price