When you buy a long put option on a stock, it's because you expect the shares to decline. In a long put spread, however, you probably have a more concrete downside target in mind. Rather than betting on an all-out plunge in the underlying equity, you might be expecting a more muted decline -- perhaps with a particular layer of support in mind that could halt a downtrend.
By selecting a likely floor for the equity's decline, and then selling a put at a corresponding strike, a bearish trader can effectively reduce the cost of entry and breakeven point on the trade. On the other hand, the trade-off is a lower potential profit than a straightforward put play.
To examine a long put spread in action, let's check out an example.
Stock XYZ is trending lower on the charts, and you expect the slide to continue during the near term. However, with the shares trading at $48, you suspect the $45 level may step up to act as a temporary floor. This area previously acted as support on multiple occasions, and you see no reason to expect it will give way during the next month or so.
To implement a long put spread, you buy to open a 47.50-strike put, asked at 0.40, and sell to open a 45-strike put, bid at 0.10. Subtracting the premium you collected for selling the short put from the premium you paid for the long put, your net debit on the trade is 0.30. Multiplied by 100 shares per contract, your total cost of entry is $30.
Since the long put spread is typically initiated for a net debit, it's considered to be a "debit spread."
The best-case scenario is for XYZ to settle exactly at $45 upon expiration. In this case, you can collect the maximum profit on the long put, which is equivalent to the difference between the two option strikes, less the net debit -- or (47.50 - 45) - 0.30 = 2.20. Accounting for 100 shares per contract, you stand to rake in a profit of $220 on the spread. Meanwhile, the short put can be left to expire worthless.
You'll reap the same profit if XYZ finishes anywhere below $45, although you'll then have to initiate another transaction to buy to close your short put.
Breakeven, meanwhile, is equal to the purchased put strike less the net debit. In this example, once XYZ falls below $47.20, your profits will begin to add up. (For comparison's sake: if you'd simply bought the long put at the 47.50 strike, the stock would need to drop below $47.10 before you'd begin to see profits, as your debit would be the entire 0.40 paid to buy the option.)
If XYZ remains at or above $47.50 through expiration, the most you stand to lose is your initial net debit of 0.30, or $30.
There's also a potential opportunity loss involved if XYZ should plummet significantly below the sold put strike before expiration. While the long put spread effectively lowers your breakeven and cost of entry, it also curbs your ability to profit from a drastic downside move.
As an option buyer, it's generally preferable to see implied volatility rise. Assuming all other factors are equal, this raises the value of your option, enabling you to sell (to close) at a higher price.
However, since a long put spread involves both a bought and sold option, the impact of implied volatility is not so straightforward. In fact, if you find yourself needing to buy (to close) the sold put, higher implied volatility could put a dent in your bottom line.
Before opting for a long put spread over a long put, carefully assess the stock's technical outlook and your own trading goals to determine whether the lower upfront cost is justified by the reduced profit potential. In the example above, XYZ would need to drop just another $0.10 to offset the premium collected on the sold put.