How put spreads work How put spreads work How put spreads work

How put spreads work

Trading Strategies

Saxo Group

Put spreads are an investing strategy that requires you to simultaneously take long and short positions on the same asset. We’ll cover this strategy’s benefits and drawbacks in more detail. 

Simply put, put spreads are a risk-management strategy because you’re holding two contrasting positions at the same time during potentially volatile market conditions. 

What are put options? 

A put option, sometimes simply known as a put, is a contract that gives the holder the right (but not the obligation) to go short on an asset at some point in the future. The contract is linked to an underlying asset (financial security). This means you’re not buying the actual asset, but a contract attached to it. 

With a put option, you’re taking out an order that gives you the right to short (sell) the asset at a predetermined price at an agreed date. The predetermined price is known as the strike price. 

So, you can take out a put option and, on the agreed date, sell the asset at a strike price agreed at the time you placed the order. This means the strike price isn’t based on the current market conditions/value of the asset. 

A put option is the opposite of a call option. Call options involve taking out a contract to go long (buy) an asset for a predetermined price on an agreed date. Again, a put option is where you go short (sell) for a predetermined price on an agreed date.

Going long vs. going short in trading 

You can only understand put spreads if you know what put options are and what going long vs. short means. 

Going long

You’re buying the asset/contract because you believe its value will increase. Therefore, you have a long-term vision, i.e. you’re going to hold the asset for a long time so you can sell it for a profit once its value increases. 

Going short 

You’re selling the asset/contract because you believe its value will decrease. Therefore, you have a short-term vision, i.e. you’re going to borrow the asset, sell it at the current market rate, then buy it back in the future for a lower price. 

The difference between the amount you initially sell for and the buyback is your profit. For example, if you “sell” for $10 and “buy” it back for $8, you’ve made a $2 profit. 

These are the two ways you can trade many financial securities, including stocks, forex and commodities. Put spreads require you to take both positions at the same time. You can think of this as covering both bases and holding two sides of the same coin. 

How to make put spreads in trading 

OK, so we know that put spreads in trading are when you hold long and short positions on the same option. There are various ways you can do this, and we’ll list them in a moment. What you need to know before that, however, is the fundamental variables you’re working with. 

When you’re executing a put spread strategy, you need to think about strike prices and expiry dates. As we’ve said, put options are based on predetermined prices and dates. Therefore, you can adjust these based on the market conditions and your preferred strategy. 

For example, a vertical put spread is where your long position (long put) and short position (short put) have the same expiration date (i.e. a date in the future) but different strike prices. Other put spreads can have different expiration dates and strike prices. This means you can employ a variety of options strategies based on the market conditions. 

Types of put spreads

The types of put spreads you can make, are:

Vertical put spread 

Vertical put spreads have the same expiration date but different strike prices. They can be used as part of a bullish (the price of an asset is increasing) or bearish (the price of an asset is decreasing) strategy: 

Bullish vertical put spread = Implement when you think the asset’s price will increase before the put options expire. 

Bearish vertical put spread = Implement when you think the asset’s price will decrease before the put options expire. 

Calendar put spread 

Also known as a horizontal put spread, this strategy requires you to find long-term put options and sell short-term put options with the same strike price. You buy the long-term options at the same time you sell the short-term options. Calendar put spreads can be neutral or bearish: 

Neutral put spread = If you believe the short-term outlook for the asset is neutral (i.e. its value isn’t going to increase or decrease significantly), you can use the current prices (at-the-money put options) to execute your simultaneous buy and sell orders. 

Bearish put spread = If you believe the short-term outlook for the asset is bearish (i.e. its value is going to decrease), you can use the future prices (out-of-the-money put options) to execute your simultaneous buy and sell orders. This strategy aims to sell the short-term options and use the long-term puts to buy back the asset at a lower price in the future (the price will be lower if your assessment of the asset’s value decreasing is correct). 

Diagonal put spread 

This put spread is where you buy long-term put options and sell short-term put options with a higher strike price. As well as different strike prices, the expiration dates differ with diagonal spreads. This means it’s possible to take advantage of bullish and bearish conditions. 

Benefits and drawbacks of put spreads 

Put spreads aren’t always a good idea, particularly if you’re a novice trader who is just learning the basics of put options. This is because they can be tricky to understand and even trickier to execute because you need to have a strong understanding of strike prices and expiry times. 

You then need to combine this knowledge with technical analysis and fundamental analysis to help determine the market conditions. 

If you’re comfortable with this, put options are a way to manage risk because you’re taking out two contrast positions. This means you’re hedging one against the other or giving yourself the ability to offset losses from one position with profits from another. This also means you can use put spreads in many market conditions, regardless of whether it’s bullish or bearish. 

Put options can be a useful tool to have in your kit. It may not be the right strategy for you, but it’s something to consider if you’re trading put options. 

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