PUT CREDIT SPREADS
DEFINING RISK AND MAXIMIZING RETURNS
Basic Framework - Put Credit Spreads:
A put credit spread strategy is an ideal way to define risk and maximize returns in options trading. This strategy involves selling a put option and buying a put option while collecting a credit in the process. When selling the put option, premium is collected and simultaneously using some of that premium income to buy a put option at a lower strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the put option serves as protection.
By selling the put option, you agree to buy shares at the agreed upon price by the agreed upon expiration date. By buying the put option, you have the right to sell shares at the agreed upon price by the same agreed upon expiration date. Thus risk is defined and capital requirements are minimal.
A credit spread is a type of option trade that risk-defines your trades and involves selling and buying an option. Let’s review a put spread as an example below.
Selling an option, you sell a put option and you agree to buy shares at an agreed upon price by an agreed upon date in exchange for premium income.
Buying an option, you buy a put option using some of the premium received from selling the option above and you now have the right to sell the shares at an agreed upon price by the same agreed upon date in exchange for paying out a small premium.
Taken together, an option spread is where you sell an option and also buy a further-out-of-the money option for downside protection. The difference in the premium received and premium paid out, is the credit spread income collected.
For example, if you sell a put 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:
A normal put spread with the same expiration dates will expire together worthless with defined risk. If the option expires between the strikes then losses will incur and if the stock moves below your protection put then max losses will occur at expiration. In a black swan event, clusters of option trades can incur max losses and really jeopardize your profit/loss statement. My goal is limit the losses and not absorb any max losses to optimize risk management.
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 then you net the $45 in premium and both option legs co-expire worthless with 100% premium capture
B) If the stock trades below $112 then you 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.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A put credit spread strategy is an ideal way to balance risk and reward in options trading.