Credit spreads might seem intimidating, but they're a lower-risk way to sell put premium
A short put spread is a neutral-to-bullish options strategy that is usually initiated when the trader believes the underlying stock will hold above a firm layer of support. Also known as a "credit spread," it's a two-legged trade that serves as a lower-risk alternative to simply selling a lone put. However, the maximum profit of a short put spread is also lower than that of a standalone short put.
Entering a Short Put Spread
Let's assume Stock XYZ has pulled back sharply from a recent high, with the decline sending implied volatility (and options prices) higher. However, the shares appear to have found support around $68 -- which is roughly 10% below the recent peak, and home to XYZ's rising 50-day moving average -- and are now hovering around $69.50.
To take advantage of both firm chart support and elevated volatilities, a trader could initiate a short put spread by selling to open the April 68-strike put for $1.72, and simultaneously buying to open the April 66 put for $0.89. The net credit on the spread arrives at $0.83 (credit received for sold put minus premium paid for purchased put). Multiplied by 100 shares per contract, the trader collects an $83 credit at the start of this trade.
Measuring Potential Gains and Losses
That initial upfront credit of $83 doubles as the maximum potential profit on the trade. That best-case scenario will be achieved as long as XYZ remains at or above $68 -- the strike price of the sold put -- through expiration. That will allow both options to expire worthless -- and this outcome can be achieved whether the stock moves sideways, slightly higher, or sharply higher during the time frame of the trade.
The breakeven for a short put spread is found by subtracting the net credit from the sold strike. In this example, the breakeven is $67.17. As long as XYZ stays above this level, the trader will profit... on paper. If XYZ should spend a significant amount of time below the strike price of the sold put ($68), the trader would potentially have to buy to close the option to take those paper profits and avoid assignment -- and given the already strictly capped profit potential on a short put spread, the additional brokerage fees in this scenario can be a dealbreaker.
The maximum possible loss is equal to the difference between the two put strikes, less the net credit -- in this case, $1.17. Multiplied by 100 shares per contract, you could be out $117 if XYZ falls to the purchased strike of $66 or below by expiration.
The maximum loss on this spread is obviously greater than the maximum reward, but it's still a lighter loss than if you had simply written a lone put. In that strategy, the risk would be equal to the strike price minus the premium received for selling the option -- that's $66.28, or $6,628 total, on a move by the underlying down to zero.
Why a Short Put Spread?
The short put spread serves as effective cash collecting strategy. While this type of credit spread is well-suited to many different types of market environments, it's particularly useful during periods of choppy price action, when volatility is elevated but there's little net movement from day to day.
By aligning the sold strikes with well-established layers of support, and adding the purchased strike to limit risk in the event of a sharp downside move, traders can use this modified put-selling approach to generate some income when more traditional long and short positions might be stagnating.