Option Strategies: Put Credit Spread

A put credit spread is similar to, but the opposite of, a call credit spread. Creating a put credit spread means selling a put at a higher strike price and buying another put at a lower strike price, both for the same underlying stock and expiring on the same day.

Put credit spreads are an easy option strategy that give you some downside protection in case the underlying stock drops. Contrast this to another bullish strategy: simply buying a call, which can easily lose 100% of its value if there’s a significant dip in the underlying.

How Put Credit Spreads Make Money

Your trading hypothesis in the case of a put credit spread is that the underlying stock will be equal to or above the short put’s strike price at expiration. If this happens, you can reasonably expect both puts to expire worthless, allowing you to keep the full net credit. Exactly like with a call credit spread, the maximum profit you can make is the net credit you receive when buying and selling the two puts. You’ll receive a larger premium for selling the short put and pay a smaller premium for buying a long put.

Why? Because the long put is further out of the money. The options market has determined that it’s less likely to have any intrinsic value at the time of expiration. And if your hypothesis is correct, it won’t have any value at that time. Its value to you between now and then is entirely as an insurance policy.

A Hypothetical Example

Remember that you’ll want to construct a put credit spread when you’re optimistic about a company’s future. A risk-averse approach is to pick strike prices below where the stock is currently trading. Let’s say $FRAC is currently trading at $50, and you think it’s likely to keep going up in the next 3 months.

Step 1: Sell a $FRAC put option (AKA a short put) with a strike price of $45, expiring in 3 months. You receive a $3 premium per share. You have sold the right (but not obligation) to sell 100 shares of $FRAC for $45 each in 3 months. You received $300 for this sale.

Step 2: Buy a $FRAC put option (AKA a long put) with a strike price of $40, expiring in 3 months. You pay a $2 premium per share. You have bought the right (but not obligation) to sell 100 shares of $FRAC for $40 each in 3 months. You paid $200 for this purchase.

Step 3: You’ve now made your maximum potential profit of $300 – $200 = $100. This is the net credit from the put spread, calculated by subtracting the premium you paid from the premium you received.

Step 4 (Best Case): 3 months later, $FRAC is trading for $55. No one wants to sell $FRAC at $40 or $45, (which your puts would allow them to do) so these puts expire worthless. You’ve cleared $100.

Step 4 (Worst Case): 3 months later, $FRAC is trading for $30. Anyone would love to be able to sell $FRAC for $45 right now, so the buyer of the put contract you sold decides to exercise it. You now have to come up with 100 shares of $FRAC and sell them for $40. The easiest way to do that is to exercise your long put: that is, to buy 100 shares of $FRAC for $45, then turn around and sell them for $40. On this transaction, you would lose (100 X $45) – (100 X $40) = $500. Subtract from that your net credit of $100, and your maximum potential loss is $400.

Two Major Takeaways: Maximum Potential Loss and Breakeven

On any put credit spread, your maximum potential loss is the difference between the strike prices minus the net credit you received on Day One. If you reach the expiration date and the market price is at or below the strike price of your long put — the option with a lower strike price — at expiration.

Not mentioned above are the intermediate cases: times when the stock is trading between the strike prices of your puts at expiration. In these cases, you may lose only part of your net credit and still turn a profit, or you will lose up to your $400 maximum potential loss. The breakeven point for a put credit spread is if the stock closes at a price equal to the short put’s strike price minus the net credit you received. In the example above, the breakeven point for $FRAC would be $44.

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