Published August 29, 2011
A short put spread obligates you to buy the stock at strike price B if the option is assigned but gives you the right to sell stock at strike price A.
A short put spread is an alternative to the short put. In addition to selling a put with strike B, you’re buying the cheaper put with strike A to limit your risk if the stock goes down. But there’s a tradeoff — buying the put also reduces the net credit received when running the strategy.
THE SET UP
• Buy a put, strike price A
• Sell a put, strike price B
• Generally, the stock will be above strike B
NOTE: Both options have the same expiration month.
WHO SHOULD RUN IT
• Veterans and higher
WHEN TO RUN IT
You're bullish. You may also be anticipating neutral activity if strike B is out-of-the-money.
BREAK-EVEN AT EXPIRATION
Strike B minus the net credit received when selling the spread.
THE SWEET SPOT
You want the stock to be at or above strike B at expiration, so both options will expire worthless.
MAXIMUM POTENTIAL PROFIT
Potential profit is limited to the net credit you receive when you set up the strategy.
MAXIMUM POTENTIAL LOSS
Risk is limited to the difference between strike A and strike B, minus the net credit received.
TradeKing MARGIN REQUIREMENT
Margin requirement is the difference between the strike prices.
NOTE: The net credit received when establishing the short put spread may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
AS TIME GOES BY
For this strategy, the net effect of time decay is somewhat positive. It will erode the value of the option you sold (good) but it will also erode the value of the option you bought (bad).
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.
If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).
Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult your tax adviser.
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