5.3.4. Credit Put Spread
With a credit put spread, the put you write will have a more expensive premium than the put you buy, because the long put is farther out-of-the-money. A credit put spread is also called a short put spread, or a bull put spread.
Short July Russell 2000 1395 Put @ 42
Long July Russell 2000 1380 Put @ 33
Suppose the Russell 2000 is trading at 1,386. You write a put with a 1,395 strike price and collect a premium of 42. To hedge against an unexpected drop in the price of the underlying, you buy a 1,380 put at 33. Since you have taken in more than you paid (a net of 9 points, or $450), your put spread is a credit spread. This $450 is your maximum gain, regardless of whether the Russell 2000 holds steady or rises in price. If the price falls, however, your losses will be capped at $300 (the 15-point difference in strike prices minus the 9-point difference in premiums times 50, which is the multiplier for the Russell 2000). Once the strike price for the long put is reached, any additional losses from the short put due to a further drop in price of the underlying will be exactly offset by the gains reaped from the long put. Your breakeven is the difference in the premiums subtracted from the higher strike price. In this case, 1,395 – 9 = 1,386.
A short put spread works for the more cautious investor, who is unwilling to risk his house and car in order to maximize his profits.
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Max Gain: Difference in premiums Max Loss: Difference in strike prices – difference in premiums Breakeven: Higher strike price – difference in premiums |
Note: The easiest way to determine whether a spread is bullish or bearish is to look at the long position. If the strike price of the long position is the lower strike price, it is a bullish position. Remember that the word BULL has two Ls, for Long the Lower strike price. I