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What is a Put Spread? – Options Trading Strategies

Hello youtube welcome to my video on bear spreads and this is the second video on doing in a series on option spreads it’s probably worthwhile by the way watching the other one first but um so what is a bear spread a bear spread is an option spread position which means that we’re buying and selling equal amounts of the same class of option in my class i

Mean calls are pods with different strike prices and in our example we’re gonna have same expiration same underlying different strike prices so it’s a bear spread so it’s designed to profit from a fall in the price of the underlying and we’re gonna build it using put so obviously the easiest way to start with that is to buy a put option and so we’ll say if

Our underlying is trading at a hundred we’re gonna buy and add the money put option and so you can see on your screen there there’s a few things but we’ve got there long put k2 and that is that the first put that we’re buying and then we’re going to sell put k1 so i’ll put with a strength of k1 and that then gives us our payoff which is the heavy black line

That you can see that’s somewhere in between them so what have we got well we’ve bought one pod option which we’ve had to spend money on we sold another put option which we’ve received money for and obviously the one we’ve sold cost a little bit less than the one that we bought and that’s because it’s further out of the money and so further out if the money

Auction should cost less and if you need to learn about in the money out the money and out of the money options i have another video on that that i’ll link to and you can take a look at but anyhow so as the price of the underlying falls when we are long this foot spread what will happen is we’ll start to make money just like being long a put option until we

Reach until the price of the underlying falls and hits strike cave and then what happens is that for every penny that we make with the put that were long we’re losing the exact same amount with the put that were short so the line starts to flatten out again now what is this employ did we do it well the reason we did it was it was cheaper as you can see here

It cost us less to buy the put spread than it would have cost to buy just to put with the striking k2 on its own and so the real reason we did this we would obviously it’s better to just be long a put option but because it costs more money we’re trying to save a little bit of money here and maybe we think the underlying is going to fall a certain amount but

It’s not going to go to zero and if you think it’s not going to go to zero why pay for four options that payoff if it goes all the way there so we’ve saved a little bit of money but we’ve got less upside than if we just bought put k2 on its own i should concede because we did save money we also hit our break-even point earlier so the break-even point there is

Where the line crosses the x-axis and then we start to make money until it falls and hit strike k1 so what is the most money we can make with this bear put spread well the most we can make is if it falls and if it falls at least 2 k1 or further but we don’t really make any additional monies that falls further so the most we can make is the difference between

Those two strike prices are the difference between k1 and k2 less the amount we spent on premium so let’s throw in a few numbers so it makes a bit of sense let’s imagine that we bought that spread for $10 so the amount we paid out for one call option less the amount we received for the other came to $10 and the difference between the strikes is $50 so given

Those numbers the most we can make is the difference between the strikes which was $50 less the amount we spent on premium which was $10 so the most we can make is $40 what’s the most we can lose the most we can lose is the amount of money we spend on premium so $10 so once again we’ve defined our risk we know exactly how much we can make and how much we can

Lose with this position over the life of the option so our bear spreader is designed to drop from a fall but a modder fall not necessarily a massive fall in the price of the underlying and it’s cheaper than if we just bought it put on its own now as i mentioned in our prior video on bull call spreads whenever we’ve bought and sold these options someone else

Has sold and bought them but they’re on the other side of that transaction so their payoff will be the exact opposite of ours so we’ll say for example if you wanted to bet that this moderate drop in the price fund entry line would not occur you could have sold this bread rather than buying it and then your payoff would be the exact opposite which would mean

That the most you could lose would be the difference between the strikes less the amount of premium that was that you received so that would once again be $40 and the most you could make is the premium that you receive which was $10 so that is a barefoot spread now because of put-call parity that i did an earlier video on you can watch that if you like the

You can create this kind of spread using either could puts or calls it doesn’t really matter what you choose to use just as long as you end up with the same sort of payoff hopefully you found this video useful if you did hit the like button if you’d like to see more like it and hit the subscribe button and if you’d like to follow along in the book there’s a

Link to it in the description below see you in the next video bye

Transcribed from video

What is a Put Spread? | Options Trading Strategies | Option Combinations By Patrick Boyle