What are Short Put Spreads?

Description

A short (or bull) put spread involves selling a put option while simultaneously purchasing a put option on the SAME underlying stock with the SAME expiration month, at a LOWER strike price. Both sell and buy sides of this spread are opening transactions and are always the same number of contracts.

This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices.

Short put spreads usually have a margin requirement, although the position initially receives a net credit to the account. The margin requirement will be larger than the credit received from the trade; the difference between the two is the total debit to the account.

For maximum profit on a short put spread, both options must expire out-of-the-money (OTM). Often investors will gravitate towards OTM options initially, in the hopes that they'll remain OTM until expiration. That way the investor keeps all of the initial credit received upfront.

Selling in-the-money options (ITM) can mean a higher reward if you're correct, but it also takes a larger move in the underlying price to achieve that reward. Remember: the strategy only achieves the maximum profit if both the options are OTM at expiration.
TradeKing's platform lets you execute short put spreads, as with any spread, as a single transaction, minimizing risk from "legging" into the position.

Market Opinion?
Neutral to Bullish.

When to Use?
Consider the short put spread when you believe the underlying's price will remain the same or advance in the short-term. This strategy is an alternative to selling an OTM put "naked", which expresses the same neutral to bearish opinion on the underlying, collects a premium upfront, but exposes the investor to unlimited risk as the underlying decreases in price

Benefit
Income generation and risk reduction. As with naked put writing, short put spreads are done for a credit (net cash inflow), but with the short put spread, part of the premium received for selling the higher strike put is used to purchase the less expensive, further OTM put. The purchase of the cheaper put limits the risk of the entire trade as opposed to the substantial risk involved with naked put writing. In other words, the trade-off is less premium received up front for the short put spread, but the benefit is a limited and known loss potential.

Risk vs. Reward
Maximum Profit: Limited
Net premium received for the entire trade. Occurs when both options expire out-of-the-money.

Maximum Loss: Limited
Limited to the difference between the strikes, minus the net premium received. Maximum loss for this spread happens if the underlying's price drops below the lower put strike price, so that both options expire in-the-money. If the underlying's price falls between the strike prices at expiration, the short put will be in-the-money and worth its intrinsic value. The purchased put will be out-of-the-money, with no value.

Break-Even-Point?
Strike price of the put sold, minus net premium received.

Volatility
If volatility increases: slightly negative effect
If volatility decreases: slightly positive effect
Changes in volatility of the underlying stock tend to show up in the time value of the options' premiums. The net effect on the strategy will depend on whether the short and/or long options are in-the-money or out-of-the-money and the time remaining until expiration. The fact that one option is sold and one is purchased makes this a more neutral strategy in terms of volatility changes.

Time Decay?
Passage of time: positive effect.
Since this strategy's goal is for both options to expire OTM worthless, time decay works in the investor's favor here.

Alternatives before expiration?
A short put spread sold as a unit for a net credit in one transaction can be bought to close as a unit in one transaction in the options marketplace for a net debit. Investors may choose to close out the position this way to cut losses or realize a profit.

Alternatives at expiration?
If both options expire in-the-money, you may be assigned on the short option, which results in a purchase on the underlying. If this happens, you may choose to exercise the long option, resulting in a sale of the underlying. This scenario yields the maximum loss. If only the short option is in-the-money, you may be assigned on the short option, leaving the account long the underlying. You'll need to either sell the underlying to close the position or, if your account has sufficient margin, you can remain long the underlying. If neither option expires ITM, both options expire worthless and you keep the full credit, achieving maximum profit for the position.

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