A put spread is an option strategy where an investor buys a put option while simultaneously selling a put option.
A put spread is used by investors to reduce the total cost of entering a trade. After having read this article, investors will gain a basic understanding of the different types of put spreads and how they can be used in their investing portfolio.
The two most commonly used put spreads are the bull put spread and the bear put spread. These two spreads are known as vertical spreads. Vertical spreads are when an investor sells a put option while simultaneously buying a put option with the same expiration date but with different strike prices.
Bull Put Spread:
The put option with the higher strike price will have a higher premium than the put option with the lower strike price. Therefore, the trader sells the more expensive put option to pay for the less expensive put option.
In a bull put spread, the investor expects both options to expire worthless with the rise in the underlying security’s price. If this happens, his total profit is the premium paid to him for selling the put option minus the cost of buying the other put option.
For example, assume a stock is trading at $50. An investor buys one put option contract with a strike price of $45 for a premium of $3 per share. At the same time, he sells one put option with a strike price of $55 for a premium of $8. Assume the stock price expires at $56. In this case, both options expire worthless. The investor’s total profit would be $5 per share (8 – 3 = 5).
Bear Put Spread:
A bear put spread is achieved when an investor buys a put option that is “in-the-money” while selling a put option that is “out-of-the-money.” From these transactions, the investor reduces the cost of entering the trade.
The maximum potential profit from this strategy is the difference between the two strike prices, minus the total cost of the option. In order for this to occur, the stock’s price needs to decrease to the point that both options expire “in-the-money.”
For example, assume a stock is trading at $10. A bear put spread is executed by buying one put option contract with a strike price of $15 for a premium of $5 per share. At the same time, he sells one put option with a strike price of $8 for a premium of $2. At this point the investor is at a loss of $3 per share.
However, assume the stock closes below $7 at expiration. The investor will profit from the difference in strike prices, minus the total cost of the options. In this case, the investor will profit $4 per share ((15 – 8) – (5 – 2) = 4).
As mentioned above, the bull put spread and the bear put spread are the most commonly used put spreads. However, there are others that can be used by investors.
For instance, a calendar put spread is when an investor buys a put option with a longer term until expiration while selling a put option with a shorter term until expiration. The bought option has the same strike price as the sold option. Two types of calendar put spreads are the neutral calendar put spread and the bear calendar put spread.
Another type of put spread is a diagonal put spread. A diagonal put spread is when an investor buys long term put options while selling short term put options with a different strike price. The sold put options have a higher strike price than the bought put options.
These are just a few basic descriptions of different put spreads to keep in mind. The main two that an investor should remember are the bull put spread and the bear put spread. These strategies are useful when an investor wants to enter a trade with little or no cost.
— The Option Specialist