Short Put Spread Option Strategy

A short put spread, also known as a "bull put spread," is an options strategy that involves selling a put option with a higher strike price while simultaneously buying another put option with a lower strike price, both with the same expiration date. This strategy is used when the investor has a moderately bullish outlook on the underlying asset and wants to capitalize on limited downside movement or sideways price action, while managing risk.

Introduction

In a short put spread, the investor aims to profit from the time decay of the options while limiting their potential loss. This strategy works best when the investor expects the underlying asset to stay above the strike price of the sold put option or, in the case of a mild decline, to stay within a specific range. The main advantages of a short put spread include a limited risk profile and the ability to generate income from the premium collected by selling the higher-strike put option.

The goal of the short put spread is two-fold:

  1. Generate Profit from Time Decay: The investor expects the stock to remain stable or increase in price, allowing the sold put to expire worthless while the purchased put remains out of the money.

  2. Profit from a Moderate Decline: The investor is willing to accept a mild decline in the stock price as long as it does not fall below the lower strike price of the bought put option, ensuring the maximum risk remains limited.

What is a Short Put Spread?

A short put spread involves two put options with the same expiration date and different strike prices. The strategy consists of selling a higher-strike put option (short put) and buying a lower-strike put option (long put). The premium received from the sale of the short put option partially offsets the premium paid for the long put option, resulting in a net credit for the position.

For example:

  • Sell 1 XYZ (Month 1) 100 put

  • Buy 1 XYZ (Month 1) 95 put

The difference between the premiums of the two options determines the net credit received when the trade is established. The risk is limited to the difference between the strike prices, minus the net premium received.

Additional Considerations

The short put spread generates its maximum profit when the stock price stays above the strike price of the sold put option at expiration. If the stock price stays above this level, both the sold put and the bought put expire worthless, and the trader keeps the entire premium received for establishing the position.

The strategy is ideal for a moderately bullish outlook, as the maximum profit is realized when the stock price remains above the sold put strike price. The short put spread is a defined-risk, limited-reward strategy, making it attractive for conservative traders who are looking for income generation with a capped downside.

The break-even point for a short put spread occurs at the strike price of the sold put minus the net premium received for the spread. If the stock price drops below the strike price of the bought put, the position incurs a loss, but the loss is capped and limited to the difference between the strike prices minus the premium received.

Example Scenario

Consider stock XYZ, currently trading at $100. The investor sets up a short put spread by selling a put option with a strike price of $100 and buying a put option with a strike price of $95, both expiring in one month.

  1. Sell 1 XYZ (Month 1) 100 put for $3.50 (total premium received = $350)

  2. Buy 1 XYZ (Month 1) 95 put for $1.20 (total premium paid = $120)

In this case, the net credit received for the position is $230 (not including commissions and fees). The investor is willing to take on the risk that the stock price could drop below $95, but the maximum loss is limited to the difference in strike prices minus the premium received.

Profit and Loss Analysis

Maximum Profit:

The maximum profit for a short put spread is realized if the stock price stays above the strike price of the sold put option at expiration. In this case, both the sold put and the bought put expire worthless, and the investor keeps the entire premium received.

Max Profit = Net Premium Received
= $230 (not including commissions and fees)

Maximum Loss:

The maximum loss occurs if the stock price falls below the strike price of the bought put option. In this case, both the sold and bought puts have intrinsic value, and the investor incurs a loss equal to the difference between the strike prices minus the premium received.

Max Loss = Difference Between Strike Prices – Net Premium Received
= ($100 – $95) – $230
= $500 – $230
= $270 (not including commissions and fees)

Breakeven Point:

The breakeven point occurs when the stock price is equal to the strike price of the sold put minus the net premium received for the spread. This is the price at which the total value of the position is zero at expiration.

Breakeven = Strike Price of Sold Put – Net Premium Received
= $100 – $2.30
= $97.70 (not including commissions and fees)

At-A-Glance Summary

Strategy: Short Put Spread
Alternative Name: Bull Put Spread
Pre-Requisite Strategy Knowledge: Put Options
Legs of Trade: 2 legs
Sentiment: Moderately Bullish
Example:

  • Sell 1 XYZ (Month 1) 100 put

  • Buy 1 XYZ (Month 1) 95 put
    Max Potential Profit (Gain): Net Premium Received
    Max Potential Risk (Loss): Difference Between Strike Prices – Net Premium Received
    Break-Even Point: Strike Price of Sold Put – Net Premium Received
    Ideal Outcome: XYZ price stays above $100 at expiration
    Early Assignment Risk: Early assignment risk applies to the short put position.

Risks and Risk Mitigation

The main risk in a short put spread is the possibility of early assignment of the short put option. If the underlying stock drops significantly, the short put may be exercised early, potentially leading to a loss. If the stock price drops below the strike price of the bought put option, the investor will incur a loss, but the loss is limited to the difference between the strike prices minus the premium received.

Early assignment risk is most likely to occur if the stock is close to the strike price of the sold put option, and there is significant time value left in the option. Traders can mitigate this risk by closing the position before expiration or by monitoring the stock's movement closely.

In the case of early assignment, the investor will need to fulfill the obligation of the sold put option and purchase the stock. If the investor does not want to take on the stock position, they can close the position by buying back the short put and selling the long put.