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What is a put credit spread? Is it right for you?
With so many options trading strategies today, how can you tell which one is right for you? By knowing each strategy’s advantages and disadvantages.
In this article, we will explore a useful options trading strategy referred to as a Put Credit Spread to help you determine if it's the right strategy for you to employ.
What is a Put Credit Spread?
A put credit spread is a trading strategy in which a trader buys a put option at a strike price below the current value of the underlying asset and sells another put option with an even lower strike price.
The difference between the two strike prices is the trader's credit (also known as the premium).
The maximum profit for this trade is equal to the net credit received, and the maximum loss is equal to the difference between the two strike prices less the credit received.
This trade is also known as a bear put spread because it profits when the price of the put options goes down.
Put credit spreads can be used when a trader has a neutral or bullish opinion of the asset in the short-term and does not want to tie up a lot of capital or take on too much risk using buying naked call options.
Advantages of Using a Put Credit Spread
The main advantage of this strategy is that it allows the investor to take on a neutral or bullish position without incurring any upfront costs.
Additional benefits include:
- The risk is defined, and there is no chance of incurring significant losses.
- The premium collected is more than the premium paid.
- When executed correctly, these are typically high probability trades.
Traders like using put credit spreads because they can profit if the market goes up, stays the same, or only goes down slightly.
They only lose if the market goes down significantly.
With three ways to win and only one way to lose, traders often use put credit spreads to generate income or hedge against downside risks.
With its limited downside and upside potential, it can be an attractive choice for those looking to manage their risk exposure.
Disadvantages of Using a Put Credit Spread
There are a few potential drawbacks to using a put credit spread.
It is a strategy that is best for new traders to avoid.
However, for more seasoned traders, to are two primary concerns.
- The commissions are higher due to having two sides of a typical trade
- The potential for profit is limited
Aggressive traders should utilize other strategies that align with their investment goals.
While put credit spreads work very well under the right market conditions, this strategy is best suited for conservative traders.
Also, put credit spreads typically don't work well if you're trying to hold them for an extended period of time.
This is because the underlying security can make sudden moves that can erode your profits (or even turn them into losses).
So, this might not be the best strategy if you're looking to hold a trade for more than a few days.
Put Credit Spread Example
To enter a put credit spread, the trader buys one put option with a strike price below the underlying asset's current price and sells another put option with a strike price below that.
The difference between the two strike prices is the trader's credit.
- ABC Stock is trading for $100 a share
- Sell Put Option at 96 Strike Price: $1.00 (per share price)
- Buy Put Options at 92 Strike Price: $0.40 (per share price)
- Total Credit: $0.60 (per share price)
Since each option represents 100 shares of a stock, a $60 credit (premium) is created with this trade.
If the stock price increases, stays the same, or only has a slight price decrease, the put credit spread will decrease in value, and the trade will be profitable.
However, if there is a substantial price reduction, the put credit spread will increase in value, and the trade will result in a loss.
The maximum profit for this trade is the net credit received; in this case, a $60 profit.
The maximum loss for this trade is the distance between the strike prices minus any credit received, for a maximum loss of $340 (the width of the strike prices, which would be $4.00, minus the net credit received of $0.60, multiplied by 100 shares).
When to Utilize a Put Credit Spread
Put credit spreads are great to use when you believe the price of the underlying asset will rise, but you do not want to risk buying naked call options.
Put credit spreads are best to use when the underlying asset remains flat or makes a sharp upward move.
They are great for traders who want to trade with low risks and pre-defined losses.
When NOT to Utilize a Put Credit Spread
Some market conditions are not suitable for put credit spreads.
When the market is very volatile and moving erratically, it can be challenging to predict which direction it will move next.
Also, when the market is near a support or resistance level, it may be about to reverse. This could cause a trader to lose money.
Lastly, it may be best to avoid using this strategy when the market is in a strong uptrend or downtrend.
The reason is that the market may continue in that direction, and your trade could end up unprofitable.
The Bottom Line: Put Credit Spread
Put credit spreads may be the perfect strategy for you if you're looking for a way to boost your returns while protecting yourself from downside risk.
They offer a high degree of flexibility and can be adapted to suit a wide range of trading styles.
They can provide an excellent return on investment with careful planning and execution.
However, as with any type of trading, it is vital to understand the risks involved and manage them effectively.
Doing so can ensure that your trading experience is both profitable and enjoyable.