Learning to Trade Put Option Spreads

While there are a wide variety of ways to trade put option spreads, the two most straightforward are vertical bull put spreads and vertical bear put spreads. Vertical spreads involve buying puts that expire in the same month but have different expiration months. These spreads apply to every type of underlying security, but we will focus on equity options for consistency. After understanding the process for creating each of these types of spreads, the tips that follow will help you to trade these strategies more successfully.

Building the Spread

To build a vertical bull put spread, you buy a put with a lower strike price and sell a put with a higher strike price, both with the same expiration date. This is known as a credit spread because the lower strike option costs less, and thus, the spread is created for a net credit. As the name suggests, this type of spread is used when you believe the price of the underlying stock will appreciate. This is because as the stock’s price rises, the value of both puts moves towards zero. Since the spread was done for a credit, you want all the involved options to expire worthless and the profit from the credit to be realized.

To build a vertical bear put spread, you sell a put with a lower strike price and buy a put with the same expiration date that has a higher strike price. Following the same logic as above, this is a debit spread because it has a net cost, but has a higher profit potential. Having a negative bias as the name suggest, you want the price of the underlying stock to fall to the price of the lower strike; below this level profits from one put is offset with loses from the other.

What Expiration Date to Pick

While the two options involved in either one of these spreads must have the same expiration date, there is no requirement that it be the front-month (the closest expiration date to the date the spread is opened). By selecting a more distant expiration date, you can impact the risk versus reward profile of the entire trade. The longer the options have until expiration, the more time value they will contain. This means that the magnitude of the credit or the debit will be greater, thus leading to a larger profit potential and a larger maximum risk.

Distance between Strike Prices

As with selecting the expiration date, if you wish to add additional risk, and thus potential reward, to the spread trade, if you pick strike prices that are farther apart, you will accomplish this objective. While this type of trade is most often created using successive strike prices ($5 apart in most cases), it is possible to select option with a greater distance between strikes to dial up the risk level. Selecting which side of the current trading price to extend the distance is part of the subtle difficulty of spread trading options.

Spreads Offer Less Risk and Less Reward

Overall, spread trading is a more stable approach to trading options than simply making directional bets. While the reward potential is also lower, one is less likely to lose significant money during the learning process by spread trading. In fact, many professionals only use spread trading because they view it as so much safer.

 

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