A strategy consisting of the purchase of a put option with one expiration date and strike price and the simultaneous sale of another put with the same expiration date, but a different strike price. Depending on whether the purchased put has a higher or lower strike than the sold put, a vertical put spread can generally be profitable if the underlying stock or index rises (a bull vertical put spread) or falls (a bear vertical put spread) sufficiently.
Similar to the Bull Call Spread, the Bull Put Spread strategy may allow the investor to profit from an upward movement in the underlying security. To utilize this technique, the investor sells puts at one strike and buys puts at a lower strike that share the same expiration date. The high-strike puts have higher premiums than the low-strike puts. As a result, the investor will receive a net inflow of capital since the price of the options sold exceeds the price of the options purchased. Consequently, bull put spreads are often referred to as ‘credit’ spreads. To achieve maximum profit, the underlying security price must rise above the strike price of the short (written) put at expiration, rendering both puts worthless.
For use when investor anticipates:
Upward market direction / security appreciation
Maximum Loss: The difference between the strike prices less the amount received to establish the spread*
Maximum Profit: Net premium received
*The maximum loss on a bull put spread is limited as long as, and only as long as, the integrity of the spread is maintained. If the investor trades out of or exercises the low-strike put, the maximum loss is no longer limited to the premium outlay. There is an additional risk associated with the expiration weekend. If the short put is assigned, while the long is not auto-exercised (because, for example, the stock closes between the two strikes) the investor ends up with a long position in the stock. Bad news during the weekend could force even greater losses on the investor before he can exit the long equity position.
EXAMPLE (Bull Vertical Put Spread)
Currently, XYZ trades at $25/share. The investor employs the spread strategy selling one in-the-money put (Strike $30) for $6.00/share and buying one out-of-the-money put (Strike $20.00) for $1.00/share. Using this strategy, the investor receives a cash credit of the difference between the premiums received and the premiums paid (6-1=$5 or $500) and this is the maximum profit the investor can earn. If the stock rises to $30.00/share, the long and short put positions expire worthless and the investor keeps the net premium received. The maximum loss is the difference between the option strikes, less the call premium received (30-20-5 = $5 or $500) (see * above). The breakeven price of 25 is calculated by subtracting the net credit of the spread from the strike price of the short option.
The Bear Put Spread may allow an investor to profit from downward movements in the underlying security. It uses exactly the opposite structure of the Bull Vertical Put Spread and requires the investor to buy a high-strike put and sell a low-strike put (with a lower premium). The sale of the less expensive, out-of-the-money put will partly offset the cost of purchasing the in-the-money put. The maximum the investor can profit is the difference between the strike prices used to create the spread less the cost of establishing the spread. If the security rises in value, the maximum the investor can lose is the difference between the premium paid for the long put and the premium received from the short put.
For use when investor anticipates:
Declining market/security depreciation
Maximum Loss: Net premium outlay (Premium Received – Premium Paid)*
Maximum Gain: The difference between the strike prices less the cost of establishing the spread
*The maximum loss on a spread position remains limited as long as, and only as long as, the integrity of the spread is maintained. [If the investor trades out of or exercises the long put, the maximum loss is no longer limited].
EXAMPLE (Bear Vertical Put Spread)
Currently, XYZ trades at $25/share. The investor believes the stock will fall and wants to participate in the downward movement but does not want to simply buy puts because of the expense/risk involved. Instead, the investor employs a spread strategy buying an in-the-money put (strike $30) for $6.00/contract and selling an out-of-the-money put (strike $20) for $1.00/contract. Using this strategy, the maximum loss is the difference between the premiums paid and the premium received* (6-1=$5 or $500). The maximum profit an investor can receive is the difference between the strike prices of the options used to create the position less the cost to establish the spread (30-20-5=$5 or $500). In this example, the strategy breaks even at $25.00/share. The breakeven price of 25 is calculated by subtracting the net debit of the spread from the strike price of the long option.
Commissions, taxes, and transaction costs are not included in any of these strategy discussions, but can affect final outcome and should be considered. Please contact a tax advisor to discuss the tax implications of these strategies. Many of the strategies described herein require the use of a margin account. With long options, investors may lose 100% of funds invested. In-the-money long puts need to be closed out prior to expiration, since exercising them could create short stock positions.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call your local Schwab office or write Charles Schwab & Co., Inc. 101 Montgomery Street, San Francisco, CA 94104 for a current copy. Member SIPC