DESCRIPTION: A put spread is a bearish strategy, with limited risk and limited upside potential. To construct a long put spread, one buys a put option and sells one with a lower strike price using the same expiration date on both options. It is sometimes referred to as a “put vertical.” It gets this name because strikes are listed vertically on the options table. Put Spreads are often referred to “Debt Put Spreads” because the price of the option purchased is higher than the price of the option sold. As a result, this strategy will require an initial outlay of cash (debit).
The short put’s main purpose is to help pay for the long put’s upfront cost. The downside of selling this put is that it caps the investor’s profit potential. There are tradeoffs for every options structure. In this case, the premium collected on the short put reduces the upfront cost and time decay relative to a single leg put option. However, the overall cost of the strategy is that it caps the investor’s profit potential.
MOTIVATION: The investor who buys a put spread seeks to capture a profit from an fall in the price of the underlying asset. The advantage of this structure vis–à–vis short selling stock outright is that one can take a position with a much smaller capital outlay upfront (margin) while taking less downside risk. Consider the following example of a long (bearish) put spread.
OUTLOOK: The investor who buys a put spread is looking for a lower price of the underlying asset to occur within a certain amount of time. Put spreads are appropriate when the investor has conviction behind an investment thesis, or they are looking for a particular catalyst to move the share price within a certain window of time.
PROFIT/LOSS: Maximum (Higher Strike – Asset Price, 0) – Net Premium Paid
The amount one earns at expiration is equal to the higher strike less the price of the underlying asset or zero, less the initial premium paid, to buy the put spread.
MAXIMUM GAIN: High Strike – Low Strike – Net Premium Paid
The gain on a long put spread is capped by the short put. If the stock price falls to or below the lower (short put) strike at expiration, both options are exercised. When this occurs, the investor sells stock at the higher strike price and simultaneously buys the stock at the lower strike price. Therefore, the maximum profit is the difference between the two strike prices, less the initial debit paid to establish the spread.
MAXIMUM LOSS: Net Premium Paid
The maximum one can lose is the premium they pay up front to establish the position. This will happen if the stock sits at a price above the higher strike at expiration. If that happens, both put options expire worthless, and the initial debit is lost.
BREAKEVEN: Asset Price = Higher Strike + Premium Paid
The investors will breakeven if the asset price at expiration exceeds the higher strike by the amount of premium paid when the trade was initiated.
VOLATILITY: Volatility is a weak driver of profitability. Since the expiration of the two options are the same, the mark-to-market gain/loss by an increase in implied volatility on the higher strike option is partially offset by the mark-to-market loss/gain on the option sold. It is the movement of the underlying price that drives the higher strike option to move more than the lower strike option.
TIME DECAY: The market value of a put spread will decline as time passes, but not quite as much as a single leg put option. This occurs because the bearish put spread involves owning a long put and short another with the same expiration. Like a single leg call or put, the rate of time decay increases, as the time to maturity falls.
ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. However, puts are assigned early only when a put option goes deep into-the-money. At this point, one has to exercise the put option they are long to sell the stock to delivered against to put option exercised.
EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Since options have a limited life, there is a risk that the put spread will expire worthless. A secondary risk is what happens with respect to assignment at expiration. If the share price closes at or near the lower strike put, the investor may or may not be assigned. They will not know if you have been assigned until your broker informs you which they will do the day following expiration.
STRATEGY PAIR: The profit/loss payoff profile for a long put spread is the same as that for a short call spread. The timing of the cash flow is the primary difference between a long put spread and a short call spread, assuming one uses the same strikes and expiration dates. The long put spread has a known debit, which is paid upfront. A short call spread generates a net credit. The profit one earns on both positions will be similar.