Summary: With a long put spread, you can anticipate a decline in the underlying value with a limited investment. While profits are capped, they are still very attractive
What is it?
A purchased put option gives the right to sell an underlying asset for a certain amount. When you write a put, you enter into an obligation to purchase.
These two trades can be combined, by buying a put (and getting a right) and at the same time selling a put with a lower strike price (take-down obligation). This is widely used and this is called a long put spread.
Why would you want to buy this?
Suppose you expect a certain stock to fall, but not indefinitely. The expected decline is a reason to buy a put, but why not take a purchase obligation at a lower level? After all, you do not expect the share to fall to € 0 and you will receive money for the obligation you enter into. In short, you reduce your investment.
Spreads have a maturity and this can vary from a few days to a few years. What you also want to know in advance is the price at which you can sell the share and for which you may have to buy. These are called the strike prices of the option and in the example below the strike prices are $140 (your right to sell) and $120 (your purchase obligation).
Example:
Let's take a look at the Apple stock. The share is currently trading around $145 and you expect a decline. You expect the share to fall towards $125 and you would like to take advantage of that. You decide to do this by buying the $125-$135 put spread.
You buy the 135 put for $7.20
You sell the 125 Put for $4.45
On balance you pay $2.75 and if your expectation comes true – the share falls towards $125– the sales right on $135 must be worth at least $10 and the purchase obligation on $125 is then worth zero.
On balance, the spread will then increase to a maximum value of $10. You can easily determine this yourself by checking what your position actually is. You may sell at $135, but you must decrease at $125. The difference between these is $10, which is also the maximum value of the spread. But you only paid $2.75 for this and you therefore make a 360% return if you saw it correctly.
When are you happy with this spread?
If the stock drops below $135. You have the right to sell at $135 and you may have to take down at $135 and you paid $2.75 for that. So you make a profit from $132.25 and lower. Optimal is, of course, a drop below $125, because then the spread will reach its maximum value.
When are you not happy?
If the stock goes up because then both options become worthless. Because who has money left over on the expiry date for a right to sell at 135 if the share can be sold on the stock exchange for $145? Exactly, nobody
When do you buy a put spread?
You buy a put spread if you think the underlying asset will fall in the coming period. You buy a put spread because the investment is smaller than just buying the put. You also sell a put and that reduces the investment. The disadvantage of this is that you maximize the chances of winning
When will you sell the purchased put spread?
You know that the maximum value of this put spread is $10. The spread will reach this value if the share is below $125 at the expiry date. But you may well be satisfied if your investment (almost) doubles to $5.50.
Perhaps the following rule of thumb can help you. Sell the spread when it trades at about 80% of its maximum value. In the case of this put spread, that would mean buying the spread at $2.75 which can be worth up to $10.00. 80% of$10 is $8. This would mean that if you can sell the spread at $8 you will have almost a 300% return.
What is your maximum risk?
The risk you run when buying the put spread is the premium you have paid. That is your maximum loss and will occur if the stock expires above the strike price you bought. In this case, it is above $135 But you can never lose more than the option premium you paid.
In short
You buy a put spread if you think the underlying asset is going to fall. You will make a great return if the expected decline actually takes place. Returns of more than 100% are then very possible.
Your maximum risk is also known in advance and that is the price you paid for the put spread. That is the maximum amount you can lose.
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