A put spread is a type of options strategy that involves buying and selling put options with the same expiration date but different strike prices. The goal of a put spread is to profit from a moderate decline in the price of an underlying asset, while limiting the risk of losing the entire premium paid for the spread.
A put spread purchase is when you buy a put option with a lower strike price and sell another put option with a higher strike price, both with the same expiration date. This creates a net debit in your account, as you pay more for the lower strike option than you receive for the higher strike option. However, this also reduces your maximum loss potential, as you can only lose the difference between the two strike prices minus the net debit paid.
For example, suppose you buy a put option on XYZ stock with a strike price of $50 and an expiration date of January 31, 2024. You pay $2 per share for this option. Then, you sell another put option on XYZ stock with a strike price of $55 and an expiration date of January 31, 2024. You receive $1 per share for this option. The total cost of this spread is $3 per share ($2 + $1), which is your maximum loss if XYZ stock falls below $50 by January 31, 2024.
On the other hand, if XYZ stock rises above $55 by January 31, 2024, both options will expire worthless and you will keep both premiums as profit. Your maximum profit will be equal to the net debit paid for the spread minus any commissions or fees. For example, if XYZ stock closes at $60 on January 31, 2024, your profit will be ($3 – $2) x 100 shares = $100.
A put spread purchase can be used as a bullish strategy when you expect XYZ stock to rise moderately in value within a short time frame. It can also be used as a hedge against downside risk in case XYZ stock drops significantly below your breakeven point ($50 – $3 = $47). However, it also has some drawbacks, such as limited profit potential and time decay risk. Therefore, it is important to choose an appropriate strike price and expiration date that suit your risk-reward profile and market outlook.
Basic Theory
A Put Spread Purchase is a type of options spread strategy where an investor simultaneously buys and sells put options with the same expiration date but different strike prices. This strategy is employed when the investor anticipates a moderate decline in the underlying asset’s price.
The two components of a Put Spread are:
- Long Put Option: Purchasing a put option with a lower strike price, giving the right to sell the underlying asset at that strike price.
- Short Put Option: Selling a put option with a higher strike price, obligating the investor to buy the underlying asset at that strike price if exercised.
The goal is to profit from the price movement within the range of the two strike prices while minimizing the overall cost of the trade.
Procedures
- Determine Market Outlook: Assess the market conditions and determine a moderately bearish or neutral outlook.
- Select Strike Prices and Expiration Date: Choose the strike prices for the long and short put options and select the expiration date.
- Execute the Trade: Buy the lower strike put option and simultaneously sell the higher strike put option.
- Monitor the Trade: Keep an eye on market movements and potential adjustments to the position as needed.
Excel Formulas and Scenario
Let’s consider a scenario where:
- Current stock price: $100
- Long Put Option Strike Price: $95
- Short Put Option Strike Price: $90
- Long Put Premium: -$3.50
- Short Put Premium: $2.00
- Number of Contracts: 1
| Description | Values |
|---|---|
| Current Stock Price | $100 |
| Long Put Strike Price | $95 |
| Short Put Strike Price | $90 |
| Long Put Premium | -$3.50 |
| Short Put Premium | $2.00 |
| Number of Contracts | 1 |
| Total Cost of Long Put | =B2+B5 |
| Total Income from Short Put | =B4*B7 |
| Net Cost | =B8+B6 |
Calculations
- Total Cost of Long Put: =B2+B5 = $95 – $3.50 = $91.50
- Total Income from Short Put: =B4*B7 = $2.00 * 1 = $2.00
- Net Cost: =B8+B6 = $91.50 – $2.00 = $89.50
Result
In this scenario, the net cost of the Put Spread Purchase is $89.50. This represents the maximum potential loss for the investor.
Other Approaches
- Adjusting Strike Prices: Investors can adjust the strike prices based on their risk tolerance and market expectations.
- Changing Number of Contracts: Altering the number of contracts can impact both potential gains and losses.
- Managing Expiration Date: Adjusting the expiration date allows flexibility in the strategy’s time horizon.
