Minimize Risk With Long Put Spreads

There are 2 primary situations in which long put spreads are an attractive alternative to simply "vanilla" put options

Aug 29, 2016 at 1:30 PM
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    In the options world, buying put options is associated with either "insuring" a long stock position or, more commonly, betting bearishly on a stock. But what if you want to purchase puts on a stock you believe is destined to dip, but could find a layer of support below? Or what if the underlying's option premiums are richer than you'd like? That's where the long put spread -- or bear put spread -- comes into play.

    To execute a long put spread, a trader buys to open a put option on a stock she expects to decline. Then, the trader will simultaneously sell to open a put on the same stock in the same series, with the sold strike often corresponding with a potential price floor. The premium collected from the sold put helps to offset the cost of the purchased put.

    For example, imagine a trader expects stock XYZ to fall from its current $50 level to $45 -- where it could find support -- but its Schaeffer's Volatility Index (SVI) is pointing to relatively rich short-term premiums. She could buy to open the 47.50-strike put that is currently asked at $1, for a total of $100 ($1 x 100 shares per contract). At the same time, she could sell to open a 45-strike put for $0.25, or $25 ($0.25 x 100 shares per contract). The investor has taken her initial entry cost -- and maximum risk -- to $75 from $100 per pair of contracts.

    However, with the lowered risk comes a lowered reward, and profit margins on long put spreads are also limited. Unlike a traditional put, where the option player sees her reward increase the further the stock falls below the breakeven point, with a long put spread, the reward is capped at the difference between the purchased and sold strikes, minus the net debit. So, in the example above, the most the trader stands to make is $1.75 ([47.50 - 45] - 0.75), or $175 per pair of contracts, if XYZ moves below $45. That's because the sold 45-strike put will move into the money, partially offsetting the gains made from the bought 47.50-strike put.

    The "sweet spot" on the trade is between $45 and breakeven at $46.75, or the purchased put strike minus the net debit ($47.50 - $0.75 = $46.75).  The trader will profit if XYZ falls into that bracket before the options expire (not accounting for brokerage fees, of course). 

    In conclusion, there are two primary situations in which long put spreads are an attractive alternative to "vanilla" put purchases. First, when the trader
     expects a stock to decline, but not to freefall. Often, this will be the case when a speculator suspects the shares could find a foothold at a certain price point that will act as support, such as a moving average or heavily populated put strike. And second, when the options player is looking to bet bearishly, but is willing to sacrifice potential gains to limit the cost of entry/maximum risk.

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