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The Bear Put Spread is set up by buying a Higher strike Put while simultaneously selling a LOWER strike Put, both with the SAME expiration date.  The Bear Put Spread is a Debit Spread, meaning you will pay a higher price for the Put that you purchase than the price of the Put that you sell.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided. 

Lets look at an example:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.

 

Bear Put Spread - GE

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).

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The last post talked about buying a CALL.  Also in a previous post I described how the risk/return graph changes when we take an opposite position. 

Lets use the same GE March $5 Call (symbol GEWCE).  If you buy the Call (Long the Call) your risk/reward at expiration looks like this:

$5 March 2009 GE Call

$5 March 2009 GE Call

And if you sell the Call (Short the Call) your risk/reward at expiration looks like this:
$5 March 2009 GE Call - Short

$5 March 2009 GE Call - Short

For this example I have assumed that you can sell the option for the same price that you can buy it.  In reality, if you look at these bid/ask prices in the previous post, you can sell the option for $5.10, a 10 cent difference.  Also, because the spread is 10 cents, it MAY be possible to buy or sell this option for $5.15. 
Notice that the graph is just mirrored about the x-axis.
If GE closes below $5 at expiration, you will have a gain of $5.20, if GE closes at $10.20, you will not gain or lose anything.  As GE goes above $10.20, you will start to have a loss, with the maximum loss being unlimited.  And if GE closes between $5.00 and $10.20 at expiration, you will have some gain.
If you sell the Call, also known as WRITING a Call, you have an OBLIGATION to purchase the underlying stock, in this example GE, for $5.00 if the holder of the option exercises the option.  It is the buyer of the Option that has a choice, or option. 
I do NOT recommend writing NAKED options, because the maximum loss is unlimited.  Naked means that you do not have another position that limits the downside risk.  Understand how options work and paper trade them before taking any positions.
To be continued–

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