Long Put Spread Option Strategy

A long put spread, also known as a bear put spread, is an options strategy in which an investor simultaneously buys a put option at a higher strike price and sells a put option at a lower strike price, both having the same expiration date. This strategy is used when the investor has a moderately bearish outlook on the underlying asset and expects its price to decrease within a specified range.

Introduction

The long put spread strategy is implemented when an investor anticipates that the price of the underlying asset will fall but wants to limit the potential loss while still profiting from the decline. The strategy involves buying a higher-strike put and selling a lower-strike put on the same asset, resulting in a net debit position. The purpose of entering into a long put spread is to reduce the cost of buying the outright put option while still allowing for some downside potential.

The long put spread allows traders to benefit from a moderate decline in the price of the underlying asset, while limiting the maximum loss to the difference between the two strike prices minus the net premium paid for the position. By using this strategy, an investor can take advantage of a downward price movement in a defined risk-reward framework.

The key objectives of the long put spread strategy are:

  1. Profit from a Decline in the Asset's Price: The investor expects the price of the underlying asset to fall, and the strategy profits from the decline.

  2. Limited Risk Exposure: The risk of the strategy is capped, which makes it more conservative than simply buying a single long put option.

What is a Long Put Spread?

A long put spread consists of two put options with the same expiration date but different strike prices. The strategy involves purchasing a put option with a higher strike price (long put) and simultaneously selling a put option with a lower strike price (short put). The premium received from selling the lower-strike put option helps offset the cost of purchasing the higher-strike put option, reducing the overall cost of the position.

For example:

  • Buy 1 XYZ (Month 1) 100 put

  • Sell 1 XYZ (Month 1) 95 put

In this example, the investor pays a premium for the 100 strike put and receives a premium for selling the 95 strike put. The maximum profit, maximum loss, and breakeven point are determined by the difference between the strike prices and the net premium paid for the spread.

Additional Considerations

The long put spread realizes its maximum profit when the price of the underlying asset falls to or below the strike price of the sold put option. The strategy is designed to profit from a moderate decline in the asset’s price, but the upside potential is limited to the net credit received for the position.

The maximum loss for the long put spread is limited to the net debit paid for the spread, which is the difference between the cost of the long put and the premium received from selling the short put. This limited loss makes the strategy attractive for traders who want to take a bearish position on an asset but wish to limit their exposure to significant downside risk.

The break-even point occurs when the price of the underlying asset is equal to the strike price of the long put minus the net premium paid for the spread.

Example Scenario

Consider stock XYZ, which is currently trading at $100. The investor expects the stock price to decrease and sets up a long put spread by buying a put option with a strike price of $100 and selling a put option with a strike price of $95.

  1. Buy 1 XYZ (Month 1) 100 put for $4.00 (total premium paid = $400)

  2. Sell 1 XYZ (Month 1) 95 put for $2.00 (total premium received = $200)

In this case, the net premium paid for the position is $200 (not including commissions and fees). The investor expects the price of XYZ to decline, and the position will profit as the stock price moves toward the strike price of the long put ($100) and beyond.

Profit and Loss Analysis

Maximum Profit:

The maximum profit occurs if the price of the underlying asset falls to or below the strike price of the sold put option at expiration. The maximum profit is achieved when the stock price is at or below $95, causing the long put to increase in value while the short put expires worthless.

Max Profit = Difference Between Strike Prices – Net Premium Paid
= ($100 – $95) – $200
= $500 – $200
= $300 (not including commissions and fees)

Maximum Loss:

The maximum loss occurs if the price of the underlying asset rises above the strike price of the long put. In this case, both puts expire worthless, and the investor loses the net premium paid to establish the spread.

Max Loss = Net Premium Paid
= $200 (not including commissions and fees)

Breakeven Point:

The breakeven point occurs when the price of the underlying asset is equal to the strike price of the long put minus the net premium paid for the spread. This is the price at which the total value of the position is zero at expiration.

Breakeven = Strike Price of Long Put – Net Premium Paid
= $100 – $2.00
= $98.00 (not including commissions and fees)

At-A-Glance Summary

Strategy: Long Put Spread
Alternative Name: Bear Put Spread
Pre-Requisite Strategy Knowledge: Put Options
Legs of Trade: 2 legs
Sentiment: Moderately Bearish
Example:

  • Buy 1 XYZ (Month 1) 100 put

  • Sell 1 XYZ (Month 1) 95 put
    Max Potential Profit (Gain): Difference Between Strike Prices – Net Premium Paid
    Max Potential Risk (Loss): Net Premium Paid
    Break-Even Point: Strike Price of Long Put – Net Premium Paid
    Ideal Outcome: XYZ price falls to or below $95 at expiration
    Early Assignment Risk: Early assignment risk applies to the short put position.

Risks and Risk Mitigation

The risk in a long put spread is limited to the net premium paid to establish the position. The maximum loss occurs if the price of the underlying asset rises, and both options expire worthless. However, the loss is capped, making the strategy less risky than buying a single put option outright.

There is a risk of early assignment on the sold put if the price of the underlying asset is near the strike price of the short put. Early assignment is more likely if the asset price is close to the strike price at expiration, and the option has significant time value remaining. This risk can be mitigated by closing the position before expiration or by managing the position as the expiration date approaches.

In the case of early assignment, the investor will be required to fulfill the obligation of the sold put option by purchasing the underlying asset at the strike price. If the investor does not want to take on the underlying asset, they can close the position by buying back the short put and selling the long put.