A long put (or long vertical) spread gives you the right to sell stock at strike price B and obligates you to buy stock at strike price A if assigned.

This strategy is an alternative to buying a long put . Selling a cheaper put with strike A helps to offset the cost of the put you buy with strike B. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.

 

Maximum Potential Profit

Potential profit is limited to the difference between strike A and strike B, minus the net debit paid.

 

Maximum Potential Loss

Risk is limited to the net debit paid.

 

Break-even at Expiration

Strike B minus the net debit paid.

 

Credence Global Bank Invest Margin Requirements

After the trade is paid for, no additional margin is required.

 

Time Decay

For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you bought (bad) and the option you sold (good).

 

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.

If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the out-of-the-money option you bought faster than the near-the-money option you sold, thereby increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).

 

Final Thought

When implied volatility is unusually high (e.g., around earnings) consider a long put spread as an alternative to merely buying a put alone. Because you’re both buying and selling a put, the potential effect of a decrease in implied volatility will be somewhat neutralized.

The maximum value of a long put spread is usually achieved when it’s close to expiration. If you choose to close your position before expiration, you’ll want as little time value as possible remaining on the put you sold. You may wish to consider buying a shorter-term long put spread, e.g., 30-45 days from expiration.

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