BULLISH INCOME STRATEGY, ALSO KNOWN AS A BULL PUT SPREAD
The Credit Put Spread is typically seen as an income generating options strategy used by somewhat bullish investors who have no intention of buying (or being assigned) the underlying stock. The long Put leg defines our risk and provides protection from us unintentionally owning stock.
The Short Put on the other hand is more typically associated with investors seeking a lower entry point to purchase the underlying stock. Such investors are willing buyers if the stock moves down and through their short strike.
So, can a Credit Put Spread actually make for a smart alternative to a Short Put?
At Options AI, we do see scenarios where this might be the case and where a savvy investor may want to contemplate using a Credit Put Spread.
Worry less about outsized downward moves
If a stock is currently trading at $100, we might be interested in selling an outright 95 strike Put at $2.50 with the intention of buying (being assigned) the stock if it falls below this level at expiration. But, what if during this period the stock had an outsized move downwards to $85 and sentiment around the stock had changed? We may be less inclined to own the stock at our $92.50 breakeven level.
So, what if we had instead sold a 95/87.50 Credit Put Spread at a net premium of $1.75 (having paid $0.75 for the 87.50 strike)?
In this example, by having switched from outright Short Put to Credit Put Spread, we have now defined our risk and have protection below our 87.50 long Put strike level.
In the scenario where the stock is below this level by expiration, we now have the option to either proceed with acquiring the stock or, to realize maximum loss on the spread (in this case 7.50 – 1.75 = 5.75) and not have to acquire the stock at the higher level.
In the scenario where the stock is between our strikes by expiration, we again have an option – this time to proceed with acquiring the stock or, to close our spread for a partial loss, partial gain or breakeven.
The trade-off for having introduced this protection and optionality is that we have received less premium ($1.75 vs $2.50) and therefore we have a higher breakeven (or theoretical entry point for buying the stock) of $93.25 rather than $92.50.
Of course, we might also want to set our long strike lower to minimize the impact on our net premium received, while still defining our risk. In other words, by finding a low-cost Put far out-the-money we may be able to sell a Credit Put Spread at a net premium close to our original $2.50 while still introducing a defined risk to the position.
Use less buying power / Risk less capital
Buying Power Required for Short Put
When opening a Short Put in a margin account (an account where you may trade more advanced option strategies), our capital (or buying power) requirement is lower, but subject to a more complex formula:
The margin requirement for an uncovered Short Put is the greatest of the following calculations multiplied by the number of contracts x 100 (multiplier):
a. 20% of the underlying price minus the out of money amount plus the option premium
b. 10% of the strike price plus the option premium
The premium received from the sale of the short put may be applied to meet the initial margin requirement.
In the example where we sell a 95 Put at $2.50 with the stock at $100, we would (according to formula (a) above) have a margin requirement of $1,750 (20 – 5 + 2.50) x 1 x 100). The $250 net premium received from the sale may be applied to this margin requirement, so our total buying power requirement will be $1,500.
Buying Power Required for Credit Put Spread
When opening a Credit Put Spread our margin requirement is equal to the width of our spread (short strike minus long strike) multiplied by the number of spreads x 100 (multiplier). The premium received from the sale of the Spread may be applied to meet the initial margin requirement.
So, in the example above where we open a 95/87.50 Credit Put Spread at $1.75, we would have a margin requirement of $750 (95 – 87.50 x 1 x 100). The $175 net premium received from the sale may be applied to this margin requirement, so our total buying power requirement will be $600.
When trading options in an individual margin account, the Credit Put Spread may provide an opportunity to use less buying power as well as defining (limiting) risk as compared to a Short Put. However, initial margin calculations can be complicated and require careful review.