Bull Spread - Short Put Spread

Bull Spread

Short Put Spread

When to use : Neutral to Bullish Trend (this captures 2 out of 3 possible scenarios)
How to establish : Short a Put and Long a lower strike Put
Debit or Credit : Credit
Margin Requirement : Yes
What is the Maximum Profit : Amount of credit received (limited)
What is the Maximum Loss : Amount between the 2 strike prices less credit received (limited)

Example :

GOOG is currently at $466.10 in early Sept
You expect GOOG to rally and have reasons to believe that it is well supported at $450, in the near term.
You choose options as it is too capital intensive to pay $46,610 for 100 shares of GOOG.

You could just simply sell a Sept 450Put option on GOOG and receive a premium(credit) for this sale. If GOOG's share price stays rather stable until option expiration, you benefit from time decay; ie you gain theta as time passes. If it rallies, then you profit from the decline in the Put's value.

But, you are worried that GOOG's shares price may suddenly drop drastically below $450, you will suffer (theoretically)unlimited losses. In fact, should GOOG's shares price ever drop catastrophically to $0, your losses will be equivalent to losing $450 per share. So, if you had sold just ONE contract of 450Put, your losses will be $45,000. This is no joking matter. But it would be a joke if GOOG shares become worthless.
Remember that one should not consider Short Put positions, if one is not prepared to purchase the stock at that Short strike price

Therefore, all naked short positions, whether Put or Call, and especially Short Call, can be HIGH risk trades. Traders must very closely monitor all naked (aka uncovered) Calls and Puts.

Hence, to mitigate the risk of a naked Put, you purchase a Sept 440 Put (just in case shit does hit the fan). The risk is mitigated because you will be insulated from further downside beyond $440. Your Long 440Put effectively serves as a "protective Put". This combination of Long and Short Puts, is known as a Short Put Spread.

This Short 450 Put position, obligates you buy GOOG at $450 and the Long 440 Put conveys you the right to sell it at $440. In return for this seemingly unfavourable trade, you receive a premium (equal to the amount of credit paid to you). In this example, the credit is 2.70. This credit compensates you for the risk involved in potentially buying high and selling low. Hence, a reward this risk assumed when you establish this Short Put Spread.

Position yields maximum profits when GOOG shares are at or above 450 at expiration, because this will render the all the Puts worthless. The maximum profit potential is the credit received; ie 2.70. The breakeven point for this trade, at expiration, is 447.30 (450 - 2.70). Hence, at expiration, if GOOG settles anything below 447.30, a loss will incur. The maximum losses is limited to 7.30 (450-440-2.70) because when GOOG trades below $450, you would be obligated to buy GOOG at $450 and have the right sell it at $440, a potential loss of $10. But, since you have already been credited $2.70 for this Short Put Spread, the maximum damage is reduced by this amount.

((an important note about Short Put Spreads : Consider that GOOG shares subsequently trades below $450 but higher than $440 any time before and up to expiration date. You will very likely be assigned 100 shares for every ONE contract of 450Put option sold. This means, you will need to have $45,000 in your account or if your broker grants you some leverage, a smaller amount is still nevertheless required to buy this 100 shares of GOOG at $450/share.
If this happens, you will end up with LONG 100 GOOG shares and a Long 440Put option position. If GOOG rebounds without going below $440, then your Long 440Put will expire worthless. This makes sense because you will most certainly not want to exercise your right to sell GOOG at $440 when you can sell them in the open market for a higher value.

In other words, for all Short Put Spreads, there is always the chance that you will be assigned with shares you are obligated to buy at a higher strike price, yet you may not necessarily want to exercise your right to sell those shares at a lower strike price. Please understand this assignment risk very well))

Profit/Loss Explanation :

((you will just have to assume that these option premiums are accurate))
Credit (means you receive) for Short Sept 450 Put = 8.60
Debit (means you pay) for Long Sept 440 Put = -5.90

Total Credit = 2.70

Maximum loss = 7.30 (440 - 450 + 2.70)
Maximum Profit = 2.70
Breakeven point = 447.30 (450 - 2.70)
Profit Range = anything at and above 447.30

Risk/Reward Ratio = 6.30 / 2.70 = 2.7; ie you risk 2.7 for a profit potential of 1.00 (but remember, you win in 2 of 3 scenarios. in fact, you can still profit if shares drop slowly but stays above 447.30. hence making the probability of a successful trade in 3 out of 4 cases)

The profit and loss is illustrated using the chart below