How to Trade Put Credit Spreads

  • June 7, 2019

Watch our video on how to trade put credit spreads.

What Are Put Credit Spreads & How to Trade Them?

  • Put credit spreads options are a bullish, neutral and slightly bearish options trading strategy. In order to run a put credit spread, you simultaneously sell and buy a put option. You pocket the premium yet limit the potential huge losses associated with naked short options if price stays above short strike by expiration. 

Options allow you to make money in any market. Hence their appeal. One of the great things about options are the many strategies you can implement. These types of spreads are one of those popular strategies that options traders move onto once they have learned the basics. Watch how to trade a put credit spread in our video above!

However, the moving parts of options affect the profit and loss of contracts. To really understand these types of put spreads, let's look at the basics of options first.

Simply put, options give you the right but not the obligation to buy or sell a stock at a certain price within a certain time. Options expire so time is a factor in profit and loss.

One contract controls 100 shares. As a result, you pay less to have control of 100 shares than you would to own the shares outright. It's a great way to grow a small account trading the safer stocks.

However, make sure you take the time to study because the Greeks, implied volatility among other factors can help or hurt you. Check out our service to learn more about them.

Put Credit Spreads

1. The Breakdown

  • Sell 1 put (this is the short put )
  • Buy 1 put (this is further out-of-the-money (OTM) from the short put you sold)

Key Reminder: like the majority of options spread strategies, you have two options when trading put credit spreads. Firstly, you can trade them in-the-money (ITM).

Secondly, you can trade them out-of-the-money (OTM). Reality is, most are traded at-the-money (ATM) and OTM.

2. Real Life Example of Put Credit Spreads

Let's take DOW for example. Currently, it is trading at $50 a share. In order to employ a put credit spread, I would sell the 48 put for $0.50 and buy the 46 put for $0.20.

The net credit I receive for this trade is $0.30 or $30. Hence why this strategy is called a “credit” spread.

The best case scenario for a put credit spread is for the underlying security, DOW stock, in this case, to rally and move up. However, if DOW sells off, the put credit spread will increase in value and it’s a loss.

Like other credit spreads, as expiration nears it will benefit from time or theta decay unless they are completely ITM.

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Put Credit Spreads

How Do Credit Spreads Make Money?

  • When implementing a credit spread trade the premium that you paid is less than the premium of the sold option, thus producing a net credit. If the price of the stock stays above or below the short anchor strike before expiration, depending on your strategy, then you get to keep the premium. That's how credit spreads make money. 

Maximum Profit = Premium Received

Maximum Loss =  Width of Strikes - Premium Received

For the example trade above, the max profit is $0.30 ($30). The max loss is $1.70 ($170). A put credit spread would be a complete losing trade if, at expiration, both legs of the spread expired in-the-money.

If DOW stays above $48 at expiration (the strike price of the short put) then the spread will be a full winner.

1. Your Break Even for Put Credit Spreads

It’s quite simple to calculate the break-even point for the put credit spread. You simply subtract the premium received from the strike price of the short call option.

In the case of DOW, the break-even point is $47.30. Check out our live trading room for more options trading examples.  

2. Why Trade Put Credit Spreads?

A bullish outlook is one of the most common reasons to run a put credit spread but not the only one. This may come as a surprise to you, but put credit spreads can be profitable in three different scenarios.

You make money if the underlying asset price moves up. And you make money if the underlying asset price stays the same. Finally, you make money if the underlying asset price moves down slightly.

Because of their ability to make money in three different scenarios, they are extremely popular trades to make. They protect your brokerage account also.

What’s more, your risk is capped. With a short put, for example, your risk of loss is monstrous. Even though it has a similar profit structure, you stand to lose a lot of money if the trade goes against you.

With a spread, you’re protected. And if you’re like me and like to be able to sleep at night, I strongly advise you to protect yourself. 

3. What About Time (Theta) Decay?

Like call credit spreads, time decay is on your side with put credit spreads. Regardless of what way the underlying goes, time premium will come out of the short option leg of the trade.

Similarly, the long call will also lose value due to time decay. However, the premium coming out of the short option leg will always be greater. Which means, it offsets the long option theta.

Spreads are one of the few strategies were time decay doesn't ultimately hurt you. Again this is apart of those moving parts that affect options.

When Should You Close out Put Credit Spreads?

  • You should close out your put credit spread prior to expiration if it has reached its maximum profit. Honestly, the best practice is to only close out the short put for a put credit spread that is profitable. This is because the short put has no more room left to decay. In other words, it has reached its maximum profit potential. 

The long, however, can go up in value so leave the long put untouched, even though it is most likely completely worthless. On the flip side, if your put credit spread has reached its maximum loss, leave it alone.

Mainly because there is always the possibility of the market moving in favor of your position.

1. What Else Should You Know About Expiration?

Like all vertical options spread strategies, you run the risk that the price of the underlying will fall between the short and long strike prices of the spread come expiration.

What’s more, the risk depends on the settlement procedures associated with the asset you’re trading.

Let’s take an asset that is settled in cash, like the SPX and EX for example. There is nothing to worry about.

But that’s not the case if you’re selling spreads on individual stocks. You run the risk of the short strike expiring in the money and the long strike expiring worthless.

If this happens, for every short put you will be long 100 shares of stock. Typically I wouldn’t see this as being an issue if you have enough buying power in your account. If not, well that’s another story. Enter the dreaded margin call.

Typically your options broker will notify you if you have any expiring options that might cause a negative margin impact on your account. But the reality is, you shouldn’t depend on your broker to monitor this for you.

You must monitor your credit spreads that are near expiration to see if you’re potentially at risk for assignment.

2. Don't Forget to Practice

Put credit spreads, like any stock market trading strategy, required practice. Practicing allows you to work out the kinks. Options are a little more complicated than stocks.

However, they have the ability to be more profitable. You're paying a premium to control 100 shares. As a result, you're not shelling out the capital to own 100 shares.

​Although you run the risk of losing your entire investment. That's why practice is so important. It allows you to figure out how volatility, open interest and the Greeks help or hurt you.

You can work out which strategy is the best and most profitable. Don't forget that 80% of options expire worthless.

Many times that's because the wrong direction was chosen or greed took over. If you have a profit, take it. You can always get back in.

3. Key Things to Remember About Put Credit Spreads

  • You make the most money when the underlying asset rallies or stays the same
  • Your position is bullish, neutral to slightly bearish
  • Trade them when you think a stock will rise in price but you don’t want to buy only call options
  • Limited risk, therefore, limited reward
  • It’s simply a short call with a long call used as a hedge to prevent unlimited upside loss
  • They are simply a protected version of short puts.
  • Time decay is on your side
  • You will not lose money if volatility explodes
  • Ally Invest is one of the cheapest online brokers to trade put credit spread
  • The opposite strategy is a put debit spread

4. Wrapping It Up

I like credit spreads as risk and profit are defined. And, the put credit spread is not as sensitive to changes in volatility.

All around, the put credit spreads strategy is a great way to profit from selling put option premium without worrying about losing your hard earned dollars due to volatility.

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