Understanding and Profiting from Short Put Spreads

A long put spread is a bearish options strategy that is usually initiated when the trader believes the underlying stock is going to decline, but has a potential downside target in mind. The two-tiered trade is an alternative to simply buying a put, reducing the investor's initial cost of entry -- and maximum risk -- on the trade. However, the profit potential of a bear put spread is also lower than that of a standalone long put.

Entering a Long Put Spread

Let's assume Stock XYZ is trading at $68, and our theoretical trader believes the shares will fall. However, XYZ options are pricing in relatively high volatility expectations, meaning the contracts are somewhat rich at the moment. Further, XYZ shares could potentially find a floor around $65.

Instead of simply buying the May 67.50 put, the trader decides to initiate a long put spread. She purchases the 67.50-strike put for $0.40, and simultaneously sells to open the May 65 put for $0.10. By subtracting the premium collected for selling the short put from the premium paid for the long put, the net debit on the trade becomes $0.30. Multiplied by 100 shares per contract, the trader's total cost of entry is $30.

Measuring Potential Gains and Losses

The spread will begin to profit if XYZ drops below $67.20 (bought put strike minus net debit) before May options expiration. The best-case scenario is for XYZ to settle at exactly at $65 upon expiration. This way, our trader can collect the maximum profit on the long put, which is equivalent to the difference between the two options strikes, minus the net debt -- or ([67.50 - 65] - $0.30 = $2.20) $220. Meanwhile, the short 65-strike put will be left to expire worthless.

On the other hand, the trader will suffer a loss if Stock XYZ remains at or above $67.50 through expiration. In this case, the trader will forfeit the initial net debit of $30, which represents the maximum loss on the play.

What's the Difference?

As mentioned above, a trader could initiate a long put spread instead of buying a put option, to reduce the overall risk and breakeven on the bearish trade. However, the trade-off could be lower profit compared to a straightforward put play.

For instance, let's say Stock XYZ unexpectedly rallied to $70 before options expiration. In this instance, the spread strategist is down only $30, while the trader who only bought the May 67.50 put is staring at a loss of $40 ($0.40 x 100 shares per contract).

Or, let's say XYZ drops to $67.15. In this instance, the spread strategist is up, since the shares are south of breakeven at $67.20. The lone put buyer would still need XYZ to drop even more -- to below $67.10 (strike minus premium paid) -- in order to break even.

However, let's say Stock XYZ plummets to $50 before May options expire. In this case, the spread strategist will still rake in only $2.20, or $220, due to the short 65-strike put. The lone put buyer, meanwhile, will be sitting on an option with $15, or $1,500, just in intrinsic value alone.

In conclusion, while the long put spread effectively lowers a trader's breakeven and cost of entry, it can also curb the ability to profit from a drastic downside move, compared to a simple put purchase. This strategy is typically used when the options trader sees a potential downside target in mind, or when premiums are running higher than usual.