Put Vertical Spread
The Put Vertical Spread, popularly known as the Bear Put Spread, is a directional trade which a trader who anticipates that the underlying price of an asset will go moderately lower utilizes. It's essentially the buy of a put option at the higher strike and sell another put option at a lower strike and has the same expiry date.
The Put Vertical Spread Setup
Consider a stock, XYZ, currently trading at $50 per share. If you anticipate a moderate drop in the stock’s price, you might set up a put vertical spread by:
- Buying a put option with a strike price of $50 for a premium of $4.
- Selling a put option with a strike price of $45 for a premium of $2.
Both of them will expire in a couple of months from now.
This strategy is appropriate for investors who are bearish on a stock but do not want to take their potential losses too high and minimize the entry cost of taking a bearish position. This is a strategic decision for someone who expects the price of the stock to drop but not collapse.
This would cap the upside to the difference between the two strikes less the net cost of the spread. In the case of a bull spread, $2 in net premium would have been paid to establish the spread ($4 paid - $2 received) so that at least some portion of the bearish cost will be offset by income from selling the put.
The breakeven on a put vertical spread is determined by subtracting the net premium paid from the strike price of the long put. In this example, the breakeven would be $48 ($50 strike - $2 net premium paid).
This scenario is when the stock price expires at or below the lower strike price, that is, at $45. Under this condition, the spread will be at its maximum value, realizing its maximum profit potential.
Maximum Profit of a put vertical spread The maximum profit on a put vertical spread is limited to the difference between the strike prices minus the net premium paid. In the example above, that would be $3 per share ($50 - $45 - $2).
The maximum loss is the net premium paid to establish the spread, here being $2 per share. It would be incurred whenever the stock price happens to be at or above the higher strike price at expiration.
The main risk is that the stock finishes above the breakeven point at expiration, causing the total loss of the premium paid. Nevertheless, this is better than the risk associated with buying a naked put option outright, as it offsets the former due to the receipt of premium from selling the lower strike put.
Time decay, or Theta, impacts this strategy in that both the purchased and sold options decrease in value as expiration draws near. This is generally beneficial, however, if the stock price is at or near the lower strike, since the decay of the short put (which you want to decrease in value) will be beneficial.
Impacts the strategy in a mixed way because volatility increase would generally increase the value of both puts, which can be more favorable for the long put bought than the short put sold, especially when the stock price is already near or below the breakeven point. A decrease in volatility would generally be less favorable as it would decrease the overall cost of the position.
A put vertical spread is an efficient strategy for traders anticipating moderate declines in the underlying asset. It presents a favorable risk/reward profile, capping both maximum potential profit and loss. This strategy is particularly attractive during periods of high option premiums because it minimizes the cost of a bearish position by collecting premiums on sold options.