What it is:
How it works (Example):
The price of Company XYZ drops. The investor, convinced that Company XYZ’s stock will not return to the original $100 at which he first purchased it, much less reach the $150 strike price, decides to use the bear spread strategy in the hope of reducing the risk of a loss.
He sells his current put option contract in the market and uses the proceeds from the sale to purchase a call option contract for the same underlying security. The new call option contract has a strike price of $50. This way, assuming the stock price continues to move in a downward direction, the investor will be able to purchase Company XYZ’s stock at a lower price.
This allows the investor to have a better chance of profiting. For example, the stock reaches $80, the investor actually profits $5 (1 contract at $100 and 1 contract at $50 = 2 contracts at $75). However, without using the bear spread, the investor would have lost $20 (1 contract at $100 – final price of $80 = $20 loss).
Why it Matters:
The bear spread strategy is one of many that enables investors to reduce their risk while still remaining in the options market.
The bear spread occurs because the investor's attitude has become bearish toward the underlying stock and decides to pursue a way to limit the risk in a trade but still allow a possibility for profit.