PUT CREDIT SPREADS
DEFINING RISK AND MAXIMIZING RETURNS
What Is A Put Credit Spread?
A put credit spread is a type of option strategy used to capitalize on neutral or bullish price movement of the underlying stock. Put credit spreads are an ideal way to define risk and maximize returns in options trading. When selling put credit spreads, it is important to follow the 10 rules of option trading while leveraging IV Rank and stock options screening software to identify trades.
Put Credit Spread Trade Setup:
A put credit spread (sometimes referred to as a bull put spread) strategy involves selling a higher strike put option (short leg) in exchange for premium income and then using some of the premium income to buy a lower strike put option (long leg) while collecting a credit in the process. Both puts have the same underlying stock and the same expiration date.
By selling the higher strike short put option leg, you agree to buy shares at this higher strike price by the agreed upon expiration date. By buying the lower strike long put option leg, you have the right to sell shares at the lower strike price by the same agreed upon expiration date. Thus risk is defined by the lower strike price long option leg and capital requirements are minimal based on the strike width of the put strikes (see below).
Put Credit Spread Advantages:
Time Decay: Traders profit from time decay or theta in combination with a rising stock price. Time decay, works to the advantage throughout the put credit spread option lifecycle. As a function of time, the value of an option contract decreases. Theta exponentially looses value as the option expiration date approaches.
Implied Volatility (IV): Put credit spreads benefit when there is a decrease or contraction in implied volatility. Low implied volatility results in lower option premiums and high implied volatility results in higher option premiums. When possible, put credit spreads should be sold when implied volatility is high to take in rich premiums and then as the implied volatility reverts to its mean, the trade can be closed for a realized profit.
The maximum profit for a put credit spread is equal to the amount of premium income received. Profits are realized as the underlying stock remains above the higher strike price in combination with time decay over the option lifecycle.
Taken together, a put option spread is where you sell an option and also buy a further-out-of-the money option for a net credit. The difference in the premium received and premium paid out, is the max profit. At expiration, both puts expire worthless if the underlying stock remains above the higher strike short put leg.
The maximum risk for a put credit spread is equal to the difference between the higher strike price and lower strike price less the premium received.
Put Credit Spread Example:
For example, if you sell a put spread option at a strike price of $112 in exchange for $86 in premium, you can use some of that premium income to buy the $107 strike put option for $41 to net $45 on the trade ($86 - $41).
In this manner, you agree to buy shares at $112, you also have the right to sell shares at $107. This will cap your losses at $455 ($500 strike width less premium received). If the stock breaks below the $107 strike protection leg, you would be assigned at $112 and exercise your right to sell shares at $107 per share. The $4.55 per share loss is the max loss you can incur and factoring in the $45 of net premium income, the net loss is capped at $455. The stock can drop to $0 per share and your loss is still capped at $455 (Figure 1).
Figure 1 – Opening a put credit spread via selling a put and buying a put while taking in net premium income during the process. Capital requirement is equal to the strike width and risk is defined to maximize return on investment.
Potential Outcomes and Scenarios:
There are three (3) possible outcomes at expiration for call credit spreads.
Sell a put strike @ $112 31DEC20 and buy a put strike @ $107 31DEC20 to net $45 in premium
A) If the stock stays above $112 at expiration: Realize the $45 in premium and both option legs co-expire worthless with 100% premium capture
B) If the stock trades below $112: Begin losing money but the $107 strike leg caps any losses below $107. If the stock falls between your strike width at ~$110 at a loss of $2 per share less the premium received of $0.45 per share will be your realized loss ($200 - $45 = $155 loss per contract).
C) If the stock trades below the put protection leg of $107: losses are now capped at your strike width of $5 per share. If you were assigned at $112, you would then exercise your $107 strike option and sell shares at $107 to cap losses at $5 per share less premium received of $45 resulting in a max loss of $455. Even if the stock was to fall to zero, you have the right to sell shares at $107 so any losses below $107 are prevented.
Closing Put Credit Spreads:
Although put credit spreads can co-expire worthless to capture 100% of the premium, managing winning trades may be necessary. Reversing the process via buying-to-close the option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open. This will allow you to close trades early in the option life cycle and realize gains.
Put Credit Spread Conclusion:
A put credit spread strategy is an ideal way to define risk and maximize returns in options trading. Put credit spreads are intended to capitalize on neutral or bullish price movement of the underlying stock. This strategy involves selling a higher strike put option (short leg) in exchange for premium income and then using some of the premium income to buy a lower strike call option (long leg) while collecting a credit in the process. Both puts have the same underlying stock and the same expiration date. The maximum profit for a put credit spread is equal to the amount of premium income received. The maximum risk for a put credit spread is equal to the difference between the higher strike price and lower strike price less the premium received. When selling put credit spreads, it is important to follow the 10 rules of option trading while leveraging IV Rank.
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