A put credit spread, also known as a bull put spread, involves selling a put option and buying another put option with the same expiration date but a lower strike price.
Traders use this strategy when they believe the underlying asset's price will either rise or remain stable. The goal is to profit from the difference in premium between the two options, and the maximum loss is limited.
BULLISH STRATEGY
Put credit spreads are considered a bullish strategy.
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They are used when you expect the price of the underlying asset to either rise or remain stable.
LIMITED PROFIT & RISK
The potential profit is limited to the net premium received when initiating the spread.
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However, the risk is limited too, as it's typically the difference in strike prices minus the premium received.
TIME DECAY ADVANTAGE
Put credit spreads benefit from time decay.
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As time passes, the value of the options decreases, and if the underlying asset remains above the higher strike price, the spread can be profitable.
PROS | CONS |
Limited Risk: Put credit spreads offer a predefined and limited maximum loss. | Limited Profit Potential: The capped profit potential means you may miss out on significant upward movements. |
Defined Profit Potential: Profit potential is capped, providing a controlled approach to trading. | Possibility of Assignment: There's a risk of assignment if the underlying asset's price drops significantly. |
Bullish Market Strategy: Well-suited for a bullish outlook on the underlying asset. | Margin Requirements: Although more efficient than naked options, still involves margin considerations. |
Time Decay Advantage: Benefits from the natural decrease in option value over time. | Market Direction Dependency: Most profitable in a bullish or stable market, vulnerable to declines. |
Margin Efficiency: Generally has lower margin requirements compared to selling naked options. |
PUT CREDIT SPREAD AND OPTION ASSIGNMENT
Assignment risk slinks in if the short put option gets in-the-money at expiration. If that happens, there's a chance the option buyer will exercise it. To avert this risk, ensure the short put is out-of-the-money at expiration.
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If not, brace yourself for the possibility of being assigned and having to buy the underlying stock at the higher strike price.
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While the risk of assignment exists, it's essential to know that assignment can be managed. If the short put is in-the-money at expiration, it may be wise to close the position or roll it to avoid potential assignment.
PUT CREDIT SPREAD EXAMPLE
Suppose an investor holds a bullish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bullish outlook involves the execution of a put credit spread. In this scenario
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Sells for $2.46 one put option with a strike of $350 expiring in nine days.
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Buys for $1.01 one put option with a strike of $347.50 expiring in nine days.
This strategic move results in a net credit of $1.45 for the pair of options, derived from the $2.46 credit from the sale minus the $1.01 premium paid for the purchase. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $145.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences an upswing, reaching $355 at the time of expiry. This results in the attainment of maximum profit, amounting to $145. The calculation involves subtracting the lower strike put option premium ($1.01) from the higher strike put option premium ($2.46), and then multiplying the result by the number of shares (100). Hence, $2.46 - $1.01 equates to $1.45, and $1.45 multiplied by 100 shares equals the peak profit of $145.
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$2.46 - $1.01 = $1.45 x 100 shares = $145
It's import to note that once the stock surpasses the upper strike price, the strategy plateaus, and no additional profit accrues beyond this point.
MAXIMUM LOSS SCENARIO
Should the DIA shares hover at $347.50 or dip below the designated low strike, the peak loss comes into play. Yet, this loss is confined to a maximum of $105, calculated as the difference between the $350 put and the $347.50 put, minus the product of the option premium spread ($2.46 - $1.01) multiplied by 100 shares.
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($350 - $347.50) - ($2.46 - $1.01) x 100 shares = $105
The investor's potential scenario envisions the stock concluding below the $347.50 per share mark upon expiration, thus marking the potential and maximum loss for this investor.
BREAKEVEN POINT
The breakeven point for a put credit spread is the Short Put Strike Price minus the net credit received.
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Net Credit Received per Share: $1.45
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Short Put Strike price: $350
The breakeven point for this put credit spread is $348.55 which is obtained from the Short Put Strike Price of $350 minus the Net Credit of $1.45. This means that at expiration, if the price of DIA is at or above $348.55, the investor will break even or make a profit. Below $348.55, the investor will start to incur a loss, with the maximum loss occurring if DIA falls to or below $347.50.
The put credit spread is your go-to move if you're betting on an asset to stay and or rise. This strategy allows the trader to pocket the net premium by selling a higher strike put and buying a lower one allowing for limited loss potential. The time decay is also a benefiting factor, making this a smart choice for stable or bullish markets. Understanding the ins and outs of put credit spreads, including assignment risks, is all part of the adventure. With this strategy, you can trade confidently and smartly, knowing exactly where your profits and risks lie. Whether you're aiming for that sweet spot of maximum profit or just looking to manage your risk, mastering the put credit spread can give you a real edge on the market. Thank you, as always, for your time. We trust this has been beneficial to your trading journey.
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- Team, C. (2024, February 3). Put option. Corporate Finance Institute, corporatefinanceinstitute.com/resources/derivatives/put-option/.
- TheOCC. (2024, January 11). What is a Put Option? www.optionseducation.org/news/what-is-a-put-option.
- Explaining Put options (Short and long) - CME Group. (n.d.). www.cmegroup.com/education/courses/introduction-to-options/explaining-put-options-short-and-long.html.
- Reducing Risk with a Credit Spread Options Strategy. (n.d.). Schwab Brokerage, www.schwab.com/learn/story/reducing-risk-with-credit-spread-options-strategy.
- Bull put spread (Credit put spread). (n.d.). www.optionseducation.org/strategies/all-strategies/bull-put-spread-credit-put-spread.
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