5.3.3.4. Credit Put Spread
With a credit put spread, the put you write will have a more expensive premium than the put you buy because a 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 ABC July 55 put @ 5
Long ABC July 45 put @ 1
Suppose ABC Cola is selling stock at $57 per share. You write a put with a $55 strike price and receive a premium of $5 per share. To hedge against an unexpected drop in the price of the underlying stock, you buy a put with a $45 strike for $1. Since you have taken in more than you paid (a net of $4), your spread is a credit spread. This $4 is your maximum gain, regardless of whether the stock holds steady or rises in price. If the price of the stock falls, however, your losses will be capped at $6 per share (the $10 difference in strike prices minus the $4 difference in premiums). 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 stock 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, $55 – $4 = $51.
A credit 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. In contrast, if the long position has a higher strike p