Credit Spread

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The put spread is one of the option spread strategies that can serve several different purposes. First however, let’s take a quick look at just what a put spread is. Here is an illustration -

Sell 7 DIA Strike 100 Puts Options
Buy 7 DIA Strike 99 Puts Options

This option spread will bring a credit into the traders brokerage account right away. That credit will be the difference between the executed prices of the two different spreads. This trade will make the trader profits as long as DIA does not breach the 100 level before or at the end of the expiration cycle. If the underlying DIA stays above the 100 price level through expiration – this trade can be profitable.

Probably the main way non directional trading investors utilize the put spread is in the way described above. It is used as a way to generate consistent profits – and the trades are placed because the investor believes the asset being traded will remain above the selected levels.

However, another way the put spread can be traded is if the investor wishes to purchase the underlying stock or index – however not necessarily at the levels where it is currently trading at. For example – let’s say that DIA is trading at 105. The trader would like to own shares of DIA – just not at 105 per share. However, the trader WOULD like to purchase DIA if it were trading at 100 per share. This would be a bargain.

So, the trader could sell a DIA 100 put and bring some premium into his / her account. If before expiration DIA drops below the 100 level, the trader could have the shares of DIA assigned – allowing the trader to not only get the stock at or around the 100 price he wished for – but in addition the trader also is able to keep the original premium brought into the account.

The above scenario is also referred to as ‘going naked’ – because the 100 puts were sold naked – or without any other asset to ‘cover’ them.

However – if the trader going ‘naked’ want to acquire some insurance just to make sure that DIA didn’t drop to 0 during the duration of the trade – instead of just selling the 100 puts naked – the trader could sell a put spread – selling the 100 put and buying a 99 put. This still brings a credit into the account – still allows the trader to purchase DIA at the 100 level if it drops there, it just in addition provides the trader with insurance from a catastrophic crash type scenario.

photo credit: Daran Kandasamy