Today I’m going to describe the fourth option strategy with two legs for options investors: the Short Put Spread. It consists of two legs, the Purchase of a Put option and the Sale of a Put option with the same expiration date and higher strike price. And we’ll also take a look at an Imtech case study.
A Short Put Spread is useful if you anticipate a (small) rise in the price of the underlying asset.
A Short Put Spread can be used in three different ways:
- Defensive; both strike prices out-of-the-money;
- A consistent market price results in maximum profit upon expiration; market price must drop to highest strike price.
- Offensive; lowest strike price (long put) out-of-the-money, highest strike price (short put) in-the-money;
- A consistent market price results in break-even or profit upon expiration.
- A (small) market price increase to the highest strike price (short put) is required for maximum profit upon expiration.
- Aggressive; both strike prices in-the-money;
- A consistent market price results in maximum loss
- A market price increase to the highest strike price (short put) is required for maximum profit upon expiration.
The investment is negative (you receive money) and amounts to the price of Short Put Spread (= price of the purchased Put minus the price of the sold Put option) x the number of contracts that you trade x contract size.
For example – if you buy 10 Put options IM 9.0 for 0.80 and sell 10 Put options with a higher strike price of 10.0 for 1.25 then you’ll receive a balance of (0.80 - 1.25) * 10 * 100 = 0.45 * 1,000 = EUR 450.
The Short Put Spread strategy does have a margin requirement. The Margin amounts to the difference between the two strike prices.
In the example above this is EUR 100 (=(10.0 – 9.0) x 100). 10 Short Put Spreads amount to EUR 1 * 10 * 100 = EUR 1,000. You cannot use the amount that you receive for other purposes. To maintain the EUR 1,000 Margin you must therefore supplement it by EUR 1,000 - 450 = EUR 550. This amount is also your maximum risk.
In order to calculate your return correctly you must take the Margin requirement into account. The return is the profit divided by the Margin x 100%.
The advantage of the Short Put Spread is that even a small Margin can achieve a high profit at consistent market prices and / or small price increases.
The disadvantage of the Short Put Spread is that if the market price upon expiration is below the lowest strike price you can lose the entire investment and Margin.
IMTECH Case Study (based on market prices as of Wednesday, February 6th, at 16:30 pm):
Imtech lists 9,85 at this particular moment in time.
Suppose that you expect the Imtech market depreciation to stay the same during the next two months and possibly even recover slightly.
Imagine that we buy 10 Put options on Imtech with a maturity of around two months (19-Apr-13) and a strike price of 9.00 for a price of EUR 0.80. And we sell 10 Put options on Imtech with the same expiration date and a higher strike price of 10.00 for a price of EUR 1.25.
This Short Put Spread initially fetches 0.45 (= 0.80 - 1.25). 10 contracts equal EUR 450.
The Short Put Spread requires a Margin of 0.55 (= (10.00 - 9.00) - 0.45). So, EUR 550.
With a consistent market rate (of 9.85) upon expiration, you’ll realise a profit of 0.30 (= 0.30 / 0.55 = +55%). 10 contracts equal EUR 300.
The Imtech market price must fall by 0.30 (from 9.85 to 9.55 = -3.0%) upon expiration to still break even with this Short Put Spread.
Above 9.55 (-3.0%) upon expiration and you’ll realise a profit using this strategy.
Below 9.00 (-8.6%) upon expiration and you’ll realise the maximum loss using this strategy. The maximum loss is 0.55 at a margin of 0.55 (= -100%). 10 contracts equal EUR 550.
Above 10.00 (+1.5%) upon expiration and you’ll realise the maximum profit using this strategy. The maximum profit is 0.45 at a margin of 0.55 (= +80%).%). 10 contracts equals EUR 450.
Short Put Spread Graphical Simulation:
The traditional pitfall for private investors using Short Put Spreads is to trade in "aggressive" in-the-money Short Put Spreads, in the hope that the price of the underlying asset rises sufficiently with time. Whilst the potential maximum profit is high, the investor may lose sight of the fact that if the market price remains consistent, then the Margin evaporates and the statistical probability of profit is small.
Consider investing in more offensive or defensive Short Put Spreads instead, which may offer smaller maximum results, but result in a much smaller loss (or profit) at a consistent underlying asset price.
Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.