When you believe a stock will go down, Bear Put (Debit) Spreads are a low risk, limited reward strategy.

You put on a  Bear Put Spread by buying a certain number of puts on a certain stock and selling the same number of puts, with the same expiration date but a lower strike price, on the same stock.

This has the effect of lowering the price of the higher-priced put you bought, with the proceeds of the sale of the lower priced put you sold.  The net effect of this transaction is that the put you bought will increase in value only until it reaches the strike price of the put you sold.  At that point increased profits on the put you bought are offset, dollar for dollar, with increased losses on the put you sold.

Bear Put (Debit) Spreads are similar to just buying put options.  The difference is you reduce the risk by selling the put with the lower strike price, the proceeds of which help you pay for the put you buy, and you limit your upside potential.

A Bear Put Spread requires buying a put option with a high strike price, which is always the more expensive option, and selling a put option with a lower strike price, which is always the cheaper option.  Since you are buying something expensive and selling something cheap, this spread always ends up costing you money, and therefore it is called a "Debit Spread", since it results in a debit to your account.

The general rule is that there is no margin requirements to a debit spread, since the put you bought provides the margin for the put you sold.  You simply pay cash for the amount of the debit plus commissions.  This is your maximum loss.

When you close out your position, whatever proceeds are realized are yours to keep, and if it brings in more than your original cost, you have a profit.

Your maximum profit per contract from a Bear Debit Spread (not counting commissions) is:

Profit = (Higher Strike Price - Lower Strike Price - Debit) *100

Your maximum loss from a Bear Debit spread is the amount it cost you to put on the trade since, if the stock rises considerably in price, both options will expire worthless.

Now let's look at a sample trade.  Biotech company Cephalon (CEPH) is trading at $53.22. To put on a Bull Debit (Put) spread, we can buy five $55 puts at $3.90.  This costs us $390 per contract or a total of $1950.

At the same time, we sell five $50 puts for $2.00.  Our net proceeds from this part of the transaction are $200 per contract for a total of $1000.

The proceeds from selling the $50 puts help offset the cost of the $55 puts.  Our net out-of-pocket cost (ignoring commissions) is $950 ($1950 - $1000).

(Graph courtesy of optionsXpress)

The bottom line here is that, while the option buyer would have to pay $1950 for this put, we now own it for $950.  The trade-off is that our profits are capped at:

Profit = (Higher Strike Price - Lower Strike Price - Debit )* Number of Contracts * 100

Profit = ($55.00 - -50.00 -1.90 ) * 100 *  5

Profit = $3.10 * 100 * 5 = $1,550

There are a number of things to keep in mind if you want to trade Bear Credit Spreads.  Among them:

1) You must be approved by your broker to trade debit spreads.

2) The general rule most brokers use for margin on spreads is that the option you own provides the margin for the option you are short, provided that it is:

a) Of the same or longer duration and

b) Of the same or higher strike price

c) On the same stock

All of these requirements must be present, or the short option will be treated, for margin purposes, just as if it were a naked option.  Always check margin requirements with your specific broker before putting on spread trades.

Your stop loss should be no more than 50 % of the debit paid.

You will likely have to pay commissions on both legs of the spread.

You must be aware that the option you sold may be exercised prematurely once it is in the money.

Discussion

Essentially, the Bull Debit Spread is similar to buying puts.  There are basically three types of Bull Debit Spreads.  They are "out-of-the-money" spreads, on-the-money" spreads and "in-the-money" spreads.

Out-of-the money spreads

An out-of-the money spread is when the price of the stock is above the strike price of the option you are buying.  These spreads are the most similar to buying an out of the money option, and are quite speculative.  The proceeds from selling the higher priced put is quite small, and often not worth your while.  By the same token, depending on how far out you're going, and how many contracts you're buying, there is no good reason to ignore out-of-the-money spreads if they can be put on for less than the cost of just buying an option.

On-the-money spreads

On-the-money spreads occur when the stock is approximately at the midpoint between the two strike prices of the options in the spread.  We are now talking about a spread that will cost you far more than an out -of-the-money spread.  Depending on how high option prices are and the volatility of the stock, as well as the time left for the options expiration, the cost of the spread will be approximately equal to the intrinsic value (the amount in the money) of the option you are buying.  The disadvantage of an on-the-money spread is the limited profit potential, and the fact that you'll probably have to close out pretty close to expiration to realize those profits.  The advantage of an on-the-money spread is that you are often able to buy an option for just its intrinsic (in the money) value.  This means that you will begin to profit from this trade as soon as the underlying stock moves down, a situation in which is quite rare in the world of options.

In-the-money spreads

In-the-money spreads occur when the underlying stock is at, or below, the lower strike price.  This is a high-risk strategy that can only work with volatile stocks with expensive options.  In this case, the underlying stock must remain below the lower strike price until expiration and the net debit must be less than the difference between the strike prices.  In other words, if the net debit is 4 dollars, and the difference in strike prices is 5 dollars, you can make 25 percent on this trade (the 1 dollar difference) when you close it out on expiration day.  This is more a mathematical possibility than a realistic one and, considering that you are still risking 100 percent of your debit, this is a low percentage trade that should probably be avoided.

The three most important things to keep in mind when trading Bear Debit Spreads are:

1) As with buying and selling options, you are risking every penny you put up to make the trade.

2) Your profit potential is mathematically limited to the difference between the two strike prices of the options you use, less the debit you must originally pay.

3) You must usually stay with a Bear Debit Spread until almost expiration day of the options in order to realize maximum profits.  This is especially true of on-the-money spreads.  In the Cephalon example above, Cephalon was at 53.22 when the trade was made.  If Cephalon moved down to the lower strike price ($50) on the day the trade was made, we would have made only a fraction of our maximum potential profit if we exited the same day.  Using theoretical prices we would have sold our $55 put for $6.85, and bought back the $50 put for $3.65 to close out the position. 

$6.85 - $3.65 = $3.20

$3.20 * 5 * 100 = $1600

Since it cost us $950 to put on the trade, our profit is just $1600 - $950, or $650, not counting commissions.  Less than half of the maximum potential profits from this trade.

The profit realized from an on-the-money Bear Debit Spread depends, to a large degree, on the degradation of the time value of the higher priced option.

The obvious question at this point is:

When do you use a Credit Spread, and when do you use a Debit Spread?

The answer is pretty straightforward.  Credit spreads depend on the underlying instrument moving in the direction or your trade, or not moving at all.  You start out at a credit, and all the underlying must do is stay in the vicinity where you made the trade for the trade to be profitable.  This is a good strategy for flat, choppy, and non-trending markets.

The debit spread has the effect of giving you a net option that is cheaper, and slower moving (a net lower Delta) then if you just bought an option alone.  Since you start out at a debit, you require significant movement for the spread to become profitable.  The combination changes in value slower than a simple option buy, protecting you (to some degree) from whipsaws.  Debit spreads work best in fast, volatile, trending markets.

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