What Is a Credit Put Spread and How Does It Work?

A credit put spread is an options trading strategy involving selling a put option and simultaneously buying another put option with a lower strike price, both with the same expiration date. Investors with a neutral to moderately bullish outlook employ this strategy on an underlying asset. It is called a “credit” spread because the premium from selling the higher strike put is greater than the premium paid for buying the lower strike put, resulting in a net cash inflow. The goal is for both options to expire worthless, allowing the investor to keep the net premium received.

Options Building Blocks

Options are financial contracts giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. Buyers pay a “premium” to the seller for these rights. The seller receives this premium upfront.

There are two types of options: calls and puts. A call option grants the holder the right to buy an underlying asset at a specified price, valuable if the asset’s price increases. Conversely, a put option gives the holder the right to sell an underlying asset at a specified price, valuable if the asset’s price declines.

The “strike price” is the fixed price at which the option holder can buy or sell the underlying security. Options are available with various strike prices, both above and below the current market value. The “expiration date” is the specific date when an options contract becomes void and can no longer be exercised. This date impacts the option’s value.

The “premium” is the price paid by the option buyer to the seller. When you buy an option, you pay this premium. When you sell an option, you receive the premium, taking on the obligation to fulfill the contract if exercised.

Understanding Credit Put Spreads

A credit put spread is a defined-risk options strategy structured by simultaneously selling one put and buying another put with a lower strike price, both expiring on the same date. This results in a net credit because the premium from selling the higher strike put is greater than the premium paid for buying the lower strike put. The strategy profits if the underlying asset’s price remains above the higher strike price at expiration.

A credit put spread consists of a short and a long put. The short put is sold with a higher strike price and larger premium. The long put is purchased with a lower strike price and lower cost, limiting potential losses. This structure caps both maximum profit and loss, providing a predictable risk-reward profile.

Maximum Profit

Maximum profit is achieved if the underlying asset’s price is at or above the short put option’s strike price at expiration. Both put options expire worthless, and the investor retains the net premium collected. For example, if you sell a put for $3.00 and buy a put for $0.50, the net credit, and thus maximum profit, would be $2.50 per share, or $250 for a standard 100-share contract.

Maximum Loss

Maximum loss is the difference between the two strike prices, minus the net premium received. This occurs if the underlying asset’s price falls to or below the long put option’s strike price at expiration. Both options finish in-the-money, and the long put’s value helps offset losses from the short put. For instance, if you sell a $50 strike put and buy a $45 strike put, and receive a net credit of $2.00, the difference in strikes is $5.00 ($50 – $45). The maximum loss would be $5.00 – $2.00 = $3.00 per share, or $300 per contract.

Break-Even Point

The break-even point is the price at which the trade neither makes nor loses money at expiration. It is calculated by taking the short put option’s strike price and subtracting the net premium received. Using the previous example where the short put strike is $50 and the net premium received is $2.00, the break-even point would be $48.00 ($50.00 – $2.00). If the underlying asset closes exactly at this price at expiration, the short put’s intrinsic value will equal the net credit received, resulting in no profit or loss.

Executing a Credit Put Spread

Executing a credit put spread involves practical steps. The short put is chosen at an out-of-the-money strike price, below the current market price. The long put is then selected with an even lower strike price, establishing the spread’s width and defining maximum risk. Strike price selection is crucial.

Expiration dates are a significant consideration. Many traders choose options with specific expiration dates. Time decay benefits credit spread sellers as extrinsic value of options erodes closer to expiration. Both the short and long put options must have the same expiration date to form a valid vertical spread.

Placing the order through a brokerage platform usually involves a multi-leg option strategy. Most online trading interfaces allow simultaneous entry of both legs of the spread as a single order. It is common practice to use a limit order for spreads, specifying the desired net credit. This ensures the trade is executed only if the combined premiums meet or exceed your specified credit amount.

Monitoring the trade is an ongoing process after execution. The spread’s value fluctuates with changes in the underlying asset’s price, implied volatility, and time decay. Traders often manage positions before expiration. Management options include closing out the spread by placing an opposite order (buying back the short put and selling the long put) to lock in profits or cut losses.

Another management technique is “rolling” the spread, which involves closing the existing spread and opening a new one with different strike prices or a later expiration date. This might extend the time horizon, adjust strike prices, or collect additional premium. Rolling can incur additional transaction costs and increase risk. The decision to manage a trade early or allow it to expire depends on the trader’s risk tolerance and market outlook.