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A long put spread gives you the right to sell stock at strike price B and obligates you to buy stock at strike price A if assigned.
This strategy is an alternative to buying a long put . Selling a cheaper put with strike A helps to offset the cost of the put you buy with strike B. That ultimately limits your risk. The bad news is, to get the reduction in risk, you’re going to have to sacrifice some potential profit.
Options guys tips
When implied volatility is unusually high ( e.g., around earnings) consider a long put spread as an alternative to merely buying a put alone. Because you’re both buying and selling a put, the potential effect of a decrease in implied volatility will be somewhat neutralized.
The maximum value of a long put spread is usually achieved when it’s close to expiration. If you choose to close your position prior to expiration , you’ll want as little time value as possible remaining on the put you sold. You may wish to consider buying a shorter-term long put spread, e.g., 30-45 days from expiration.
The setup
Sell a put, strike price A
Buy a put, strike price B
Generally, the stock will be at or below strike B andabove strike A
NOTE: Both options have the same expiration month.
Who should run it
Veterans and higher
When to run it
You’re bearish, with a downside target.
Break-even at expiration
Strike B minus the net debit paid.
The sweet spot
You want the stock to be at or below strike A at expiration.
Maximum potential profit
Potential profit is limited to the difference between strike A and strike B, minus the net debit paid.
Maximum potential loss
Risk is limited to the net debit paid.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, the net effect of time decay is somewhat neutral. It’s eroding the value of the option you bought (bad) and the option you sold (good).
Implied volatility
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. That’s because it will decrease the value of the near-the-money option you sold faster than the in-the-money option you bought, thereby increasing the overall value of the spread.
If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons. First, it will increase the value of the out-of-the-money option you bought faster than the near-the-money option you sold, there by increasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the downside).
Recommended
Long Call
A long call gives you the right to buy the underlying stock at strike price A. Calls may be used as an alternative to buying stock outright. You can profit if the stock rises, without taking on all of the downside risk that would result from owning the stock.
A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short.
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