Imagine a stock is currently trading at $100. An investor believes that the stock will not fall significantly over the next month. They decide to employ a put credit spread to potentially profit from this outlook.
Here’s how the investor sets it up:
- Buy a Put: To limit potential losses in case the stock does take a dramatic downward turn, the investor buys a $90 put option for a premium of $1, or $100 for one contract.
- Sell a Put: The investor sells a $95 put option for a premium of $3. This means the investor receives $300 (since 1 option contract represents 100 shares) for selling this option. The act of selling this put indicates the investor’s belief that the stock will remain above $95.
Outcome possibilities:
The net credit received from this spread is $200 ($300 received from the sold put minus $100 paid for the bought put).
- Stock remains above $95 at expiration: Both put options expire worthless. The investor keeps the entire net credit of $200.
- Stock falls below $90 at expiration: Both put options are in-the-money. However, the maximum loss is capped at $300, which is the difference between the strike prices minus the net credit received ($500 – $200).
- Stock ends up between $90 and $95 at expiration: This is where the situation gets trickier. The sold $95 put will be in-the-money, but the $90 put will expire worthless. The exact profit or loss will depend on where the stock lands in this range.
By employing the put credit spread, the investor can profit from a neutral to bullish short-term outlook on the stock, while also defining and capping potential losses.
Disclaimer: This article is for informational purposes only and is neither investment advice nor a solicitation to buy or sell securities. Investing carries inherent risks. Always conduct thorough research or consult with a financial expert before making any investment decisions.
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