Put Credit Spread

Education Frequently Asked Questions
1

Note: This involves Risk
You Could Lose Money

I noticed more mentions of Put Credit Spread’s on the TF and I thought I try and make a guide which is mostly copy and pasted.

Please consider discuss any potential Credit Spread’s on the forum or with @TheHouse, @The_Ni , @Kryptek or the other gods before jumping in. - In the past I have seen these break and destroy ports and traders. Always utilize the knowledge and resources we have here, before going in blind. - I am sure some others a bit more familiar could add quite a bit here.

  1. Sell a put (naked or covered)
  2. Buy a cheaper put

So for a put credit spread, you are just selling a put while also buying a protective put to limit your downside. You are selling 1 put while also buying 1 cheaper put… and your profit is the difference between these two. The extra premium that is left after buying your cheaper protective put is your maximum profit.

You’d generally sell a put if you think the stock is going to go up, and because the put you are selling is at a higher premium (because of the higher strike price) than the put you are buying, this is a strategy you’d implement if you are bullish.

What makes this so appealing is that—while your upside is obviously lower—your downside is greatly reduced. It goes from being a 100% downside (if selling a cash covered put), to having a limit, and one that you can set depending on how aggressive you want to be for your profit target.

Example - Using Robinhood (this is an example - not a recommendation)

TSLA is trading @ 699.00 - and we want to play 690/600 Puts

image

To get an idea how this might work out we can use optionstrat.

image
image1278×875 294 KB

Potential Mistakes

Here’s some mistakes that could be made with a put credit spread - just some not all:

1. Making the spread too small

If you pick strike prices on the puts that are too close together, you’ll get hardly any profit for the capital you are risking. To avoid this, it is recommend estimating the yield of your credit spread based on how much capital you’re risking AND how long your capital is tied up (the expiry date). If it’s too small a yield, either don’t take the trade, buy a cheaper put, or sell a more expensive put.

2. Setting your protective put too low

If you pick a protective put that is so far out of the money that only a “Covid Lockdown” event would provide you any sort of protection, well you’re risking a lot more downside risk and getting yourself into selling a naked put territory. In fact, some might argue at that point you’re just throwing your money away on the protection (like if the underlying stock needs to drop 20% or something ridiculous). You can be aggressive when it comes to setting your credit spread, but don’t be too greedy.

Just remember the old adage: Bulls make money, bears make money, but pigs get slaughtered…

3. Not setting a profit target

When you have a profit target of say, 5%, you’re able to capitalize on either the swings of the stock and/or time decay—and once that profit is realized you can free up capital for another trade.

4. Not doing Due Diligence on the stock

This should go without saying, should be the 1st step in the analysis. - Some simple things like history, recent news, and earnings call date is a great start.

5. Not checking volume

Liquidity is always something you should consider when trading options, and especially when trading. If you’re setting profit targets but trading options with low volume, then don’t expect your trades to be filled when trying to exit at least not quickly. Option chains post the volume for a contract that day, and so check to make sure that there is decent activity before entering the trade if you’re expecting to get out to take profits off the table later.

8 Likes
2

Thank you for getting this discussion started, @internetkings ! Spreads are a get way to take directional bets with much better r/r profiles than naked calls or puts, as long as we manage the risk well. @thots_and_prayers plays spreads very often and is much better versed at this than me, so hope we can benefit from her thoughts here too!

Perhaps we can one more item to the list of hazards:

6. Assignment Risk

The short position one writes (i.e. the put one sells) can be assigned when it is in-the-money. Of course, we are writing this entire spread because we think prices will go up, or at least stay around the same level, but reversals can happen. Please build in that margin of error, as otherwise assignment can be very painful. In this case, you’d have to cough up $69,000 if the 690P is ITM and assigned.

Sometimes, on rare occasions, you might get assigned even if the put is out of the money - something that tends to happen at expiration, when it does. (See second link below.)

A stop should usually take care of this, which we should have anyway, but because the contract value frontier moves (red to white to green) it’s not a surefire safety. If you do get assigned and were not planning on it, please call your broker immediately - they are often able to figure out a “friendly” solution. You’ll still be down money, but your account won’t blow up.

Some useful resources:

3 Likes
3

When it comes to assignments, while it is true that once your contract goes ITM you run the risk of getting assigned, there are a few things one should know and consider before letting that prevent you from adopting a trading strategy that may suit you better.

First, consider your breakeven point on the short legs of your options trade. Just because your contract is ITM, does not mean you’d be losing money even if you are assigned. In the same way that you have a break even price, the buyer of your contract also has a breakeven price which he is looking to hit before exercising becomes a reality. Additionally, the buyer of your contract will need to have the buying power in order to exercise, which further reduces the likelihood the exercise will be made.

Secondly, perhaps the best part of selling options regardless of strategy. Even if your contract goes ITM and past your breakeven, you can always roll your contract further out and to different strikes so that your risk of assignment becomes low again. This method essentially make assignments ‘Your choice’ rather than the buyer’s choice. If you are not trading penny stocks, the stock price will never run away from you that fast where you won’t be able to recover your money. Regardless of how badly you messed up, you should be able to trade time for premium and eventually make your money back without a hit to your account balance.

Lastly, assignment is not necessarily a bad thing. My second point pretty much allows you to select and massage the price you’re willing to pay for the stock. There will be a point where the stock levels off and shows good support. You should be able to land your strike near it while you’ve collected a ton of premium. Even if assignment happens you are getting the shares at a steep discount where you can sell for profit.

5 Likes
4

I appreciate the tag, this is an area im working on understanding better and there are people in Valhalla that are better suited to add input here. Ill def be paying attention though, thanks for putting it together!

1 Like
5

A note to supplement the above points, specifically for users of Robinhood/Webull, and probably other brokerages too. If there is considered to be an assignment risk at expiration for an underlying that your account size cannot handle, the brokerage can (and will) FORCE CLOSE YOUR SPREAD AT THE ASK, sometime between 3pm and 3:30pm on expiration day. Each brokerage will determine whether to force close on you differently. In the topic TSLA 690/600 example, this means depending on where TSLA is going into close (or even afterhours; google ‘pin risk’) you’ll get auto-closed unless you have at least $69,000 in cash+margin available.

A few expiration day examples using the TSLA $690/600 put credit spread:

  1. TSLA is way above the top leg at $750. Both legs expire worthless, you keep the full credit, you get max profit, good job.

  2. TSLA is slightly above the top leg, at $694 going into the last hour. You think to yourself, as long as it closes above $690, I get max profit, right? Except it’s very possible tesla could fall $5 and close just below $690, resulting in your short put being assigned and you having to buy 100 shares at $690, but you wouldn’t have known to exercise your 600P before the fact.
    ->Unless you have 69k cash+margin this will be auto-closed.

  3. TSLA is between the legs, maybe $630,$670, going into close.
    ->Your short put will definitely be assigned and you probably won’t exercise your long leg at a loss, so unless you have $69k cash+margin you’ll likely be auto closed.

  4. TSLA is at $595, slightly below your bottom leg. You’ll still get closed out, and the brokerage is probably doing you a (small) favor in this case. That’s because just like in scenario 1, it’s possible for the stock to go up and close just above $600 in the last hour, resulting in short put assignment and you buying the shares.
    ->Unless you have $69k cash+margin this will be auto-closed

  5. TSLA is way below your bottom leg, at $550, going into the last hour. No auto-close. Your short put gets assigned, and you exercise the long. you buy 100 shares at $690 and sell those shares for $60,000. Max loss, you should’ve closed out earlier.

2 Likes