Buy a Put Spread

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Buy a Put Spread

The strategy uses two options: Buying a put option and selling a put option with a lower strike price than the bought put. This trade is established for a net debit and is a defined risk strategy (the maximum risk is known at the time of trade). 

This is a bearish strategy that benefits from a reduction in cost due to selling the lower strike put option, with the trade-off being a cap on your potential profit.

The maximum profit potential of the trade is easily calculated. Simply take the difference between strike prices and subtract the net premium paid for the put spread. The maximum loss is the total premium paid for the put spread.

 

WHEN WOULD YOU USE IT? 

If you think the market will fall but have a target in mind for how far the stock will drop. If you think that the put option you want to buy is too expensive (for example if volatility is high, or it’s in the money with lot of intrinsic value already priced in), then selling a put option against this will lower your cost basis. This is a good way to get gearing on a trade as well, because you can afford more put spreads to give you greater exposure to the stock. 

 

BUY A PUT SPREAD EXAMPLE 

Let’s look at buying a put spread example. XYZ is trading at 412. An options trader executes buying a put spread by buying a 400 put at 21 and selling a 360 put at 9. The net debit and maximum loss on this trade is 12 (21-9). 

If XYZ PLC stock falls and is trading below 360 on expiry of the options the maximum profit on this trade is realised. Technically the short 360 and long 400 puts would be exercised simultaneously, resulting in you purchasing the shares for 360 while simultaneously selling the shares at 400. In practise you would normally sell your put spread for close to 40 being the difference between the two strike prices. 

If the stock closes above 400 both options expire worthless and the initial debit paid is lost.

 

BUYING A PUT SPREAD SUMMARY

CONFIGURATION:

  • Buy a put option
  • Sell a put option with a lower strike and the same expiry

OUTLOOK:

  • Anticipate a moderately bearish move

TARGET:

  • Underlying stock price expires below strike of the sold put option

PROS

  • Defined risk strategy
  • Cheaper to execute than buying an outright put so can get higher exposure for the same premium

CONS 

  • Your profits are capped by the sold put
  • The net effect of time decay is somewhat neutral. It’s Eroding the value of the option you purchased(bad) and the option you sold (good)

Important information: Derivative products are considerably higher risk and more complex than more conventional investments, come with a high risk of losing money rapidly due to leverage and are not, therefore, suitable for everyone. Our website offers information about trading in derivative products, but not personal advice. If you’re not sure whether trading in derivative products is right for you, you should contact an independent financial adviser. For more information, please read our Important Derivative Product Trading Notes.

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