Everything You Need to Know About Put Credit Spreads

Founder and CEO Bernie Schaeffer explains put credit spreads

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    What is a put credit spread? A put credit spread is a neutral to bullish options strategy with defined risk and reward. This means that you will have a max profit and a max loss that is known before you execute the trade. Put credit spreads can also be referred to as “bull put spreads” but are not to be confused with “put debit spreads” or “bear put spreads.” If you have sold naked puts or cash-secured puts before then a put credit spread is essentially the same trade, except you also buy a lower strike put to define your risk. To configure the strategy, you would start by selling a put, and then you would buy a lower strike put within the same order.

    An Example of a Put Credit Spread or Bull Put Spread

    Stock XYZ is trading at $100 per share.

    You sell one $90 strike put for -$1.00 and you buy one $80 strike put for $0.50.

    You will receive a net credit of -$0.50.

    When you are trading put credit spreads, you are generally only looking to profit on the option that you sold. This is because the option that you shorted is worth more than the one you bought. If your assumption is correct and stock XYZ stays neutral to bullish then both put options will lose value. However, the $90 put that you sold will lose more value than the one you bought and therefore you would profit on the trade. Let’s say that after you sold this put credit spread stock XYZ moved up 5 points to $105 per share:

    The value of your $90 strike put goes from $1.00 to $0.50, generating a $0.50 profit from this leg of the trade.

    The value of your $80 strike put goes from $0.50 to $0.25, resulting in a $0.25 loss from this leg of the trade.

    The net credit for this spread dropped from $0.50 to $0.25, resulting in a $0.25 profit on the spread.

    Calculating Max Profit and Max Loss for Put Credit Spreads

    The maximum profit potential for a put credit spread is equal to the premium you receive.

    So, for our above example where we collected a net credit of $0.50, that means our maximum profit potential is $50 due to the 100 share multiplier with options trading.

    The maximum potential loss for a put credit spread is equal to the width of the strikes to premium received.

    Using the above example again, the width of the strikes is 10 (90 - 80), and the premium received is $0.50. Therefore, our maximum loss potential for this trade would be $9.50 per share or $950. To receive max profit of $0.50, you must let both options expire worthless. If stock XYZ stays above $90 on the expiration date, then both contracts will be out of the money and expire worthless. To reach maximum potential loss, stock XYZ would have to be below $80 per share on expiration. If stock XYZ expires between the two strikes at $85, then you will lose money on both legs of the trade. The $80 put would expire worthless and you would be assigned 100 shares at $90 resulting in a $450 total loss.

    Assignment Risk With Put Credit Spreads

    Taking assignment on a put option means you will be forced to buy 100 shares of stock at the strike price. This means that if you have a short put option that is in-the-money, then you are at risk of being assigned. Most of the time puts will not be exercised before expiration, but if the strike price of the put option you sold is in-the-money (or above the share price) at expiration then it will be auto assigned by your broker. The put option that you bought does not come with assignment risk because you can only be assigned on options that you have sold. Instead, with the put option that you bought, you will have the right to sell 100 shares at the strike price. Let’s break down both contracts so we can visualize our obligations and rights for each option.

    Short one $90 put at 1.00 = obligated to buy 100 shares at $90 and RECEIVE $100 in premium ($9,000 notional value)

    Long one $80 put @0.50 = right to sell 100 shares at $80 and PAY $50 in premium ($8,000 notional value)

    It is important to note that if you are assigned a short put option you will keep the premium that you received for selling it. As a put buyer, you will be forced to pay the premium you paid for it to the seller in exchange for the right to sell your shares to them.

    Managing Risk With Put Credit Spreads

    Using put credit spreads to collect premium is a high probability trade that will win if the stock moves up or doesn’t move at all. We know there is no free lunch in the markets so when selling put credit spreads you have a higher probability of winning in exchange for a less favorable risk to reward when selling options that are out of the money (below the share price). Due to this, you must know how much risk you are taking and be able to manage it. If you have a $10,000 account and you decide to use all of it to sell put credit spreads, then your max loss is your entire account.

    The most conservative way to trade put credit spreads is to have enough cash on hand to accept assignment of all the puts you have sold. So, if you sell the same credit spread as our previous example then you should set aside $9,000 in your account in case you are assigned the 100 shares at $90. Even though you only need $1,000 to sell a 10-wide spread this doesn’t mean it is a good idea to sell 10 and use all your buying power. With a large move down in the market this could wipe out your whole account.

    As you get more experience you can start to use more leverage to generate better returns. As a rule of thumb if you must ask whether it is a good idea to use margin then you probably do not understand the risks enough. Make sure to always consider the worst-case scenario when trading put credit spreads because there is always a chance of it happening. It is recommended to have a plan of what to do if the market moves against you before getting yourself into a trade. Options can be very risky if you over-allocate your account so if you are unsure about your risk tolerance then it is recommended to paper trade with fake money before using your own money.

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