Put Credit Spreads – Structure, Risk and Reward
When (and why) to use put credit spreads:
Put credit spreads have a very defined risk, as well as a defined profit potential. For bullish trades, we sell put credit spreads, which means we take in a credit for the trade. To close a put credit spread, we buy it back (debit).
I use put credit spreads when I expect sideways to slightly upward movement in a stock. For put credit spreads to work, we just need to stock to stay above the put strike that we sell. Whereas with a call debit spread, we need the stock to make an upward move relatively quickly. Put credit spreads often have a higher probability of success than other spreads. The lower risk is appealing, even though put credit spreads also have a defined profit potential.
Put credit spreads have two legs:
1) A put that we sell
2) A put that we buy
The put that we sell is the put we make money on. The put that we buy is purely for risk definition, for our protection. If we didn’t buy this put, we’d be selling naked puts, which we never want to do.
For a bullish put credit spread, we sell a put at a higher strike, and buy a put at a lower strike.
Here’s an example:
Stock XYZ is currently trading at $101.50 and we think it will stay above $100 through next week. So we sell the $100 put and buy the $95 put for a credit (we take in money) of $2.40 for next Friday’s expiration date.
Risk and Reward
We make a profit if Stock XYZ trades above $100 by expiration. If Stock XYZ trades below $100, we’ll have a loss. However, our loss is defined.
This put credit spread is 5-wide (the difference between the strikes is $5).
Our max loss on a put credit spread is the width of the spread, minus the credit we took in for the trade. So for our example in Stock XYZ, the width is $5.00 and we took in a credit of $2.40. $5.00 minus $2.40 is $2.60, which is our max loss on the trade. And of course, since a contract is actually 100 shares, we multiply it by 100, so our real max loss is $260.
Our max gain on a put credit spread is the credit we took in for the trade. Our goal is to keep that credit. For our example in Stock XYZ, we took in a $2.40 credit. That’s our max profit potential per contract. Since an options contract is actually 100 shares, we multiply it by 100, so our max profit is $240.
However, I’ve got a rule for exiting put credit spreads. I typically don’t let the put credit spread expire to keep the whole credit because it’s not worth risking a loss if the market turns just to get every penny of the credit. My target is to purchase the put credit spread back when I’ve reached 80% of my potential profit.
For our example in Stock XYZ, 80% of $2.40 is $1.92. When I’ve realized $1.92 of that credit, I’ll buy back the spread. 20% (what’s left after the 80%) multiplied by $2.40 is $0.48. So I’d set my exit order to buy the put credit spread back at $0.48 (or even round up to $0.50). I don’t want to risk the $2.00 I’ve gained for another 48 cents.