Sell a Put Spread

Selling a Put Spread

The strategy uses two options: Selling a put option, and buying a put option with a lower strike price than the sold put with the same expiry. This trade is established for a net credit and is a defined risk strategy (the maximum risk is known at the time of trade). 

This is a bearish strategy that benefits from the protection of capping your maximum loss with the trade-off being you have to pay for this protection.

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

WHEN WOULD YOU USE IT? 

If you think the market will rise but want protection in case your assumption is incorrect and you want to cap your potential losses. If you don’t want to take up the underlying stock it’s prudent to sell put spreads to lock in what you’re able to afford to lose.

SELL A PUT SPREAD EXAMPLE

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

If the stock closes above 400 both options expire worthless and the initial credit received is retained.

If XYZ PLC stock falls and is trading below 360 on expiry of the option the maximum loss on this trade is realised. Technically you would be exercised on the 360 puts selling the shares for 360 while simultaneously buying the shares at 400 with the exercise of the 400 put locking in a 40 loss minus the credit received If the stock closes below 360. In practise you would normally buy your put spread back for close to 40 being the difference between the two strike prices. 

SELLING A PUT SPREAD SUMMARY

CONFIGURATION:

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

OUTLOOK:

• Anticipate a bullish or neutral move. Volatility falling.

TARGET:

• Underlying stock price expires above strike of the sold put option.

PROS

• Limited risk strategy.
• Takes advantage of time decay, as both options near expiry the value of the spread becomes cheaper to buyback.
• Lower margin requirement compared to selling naked puts.

CONS 

• Can be exercised early if American style.
• Limited profit potential.
• Can be margin intensive if the underlying asset rises sharply.