Selling Put Spreads for Income

If you’re unfamiliar with options, click here to learn the basics and key terms/ideas you should know, then continue! Before we discuss put spreads, make sure you are familiar with selling put options for income. Click here to learn about selling puts.

Here’s how selling a put spread works. You sell a put option. At the same time, you buy a put option at a lower strike price. This is called “selling” a put spread because you collect a premium upfront.

For example, if you want to sell a put spread for a stock currently trading at $55. You first sell a put at a strike price lower than the stock price. Then you buy a put at a strike price lower than the strike price of the sold put.

In our example, we sell a put at a strike price of 50$ and get a ten-cent credit per share. So we get a $10 credit because options are sold on lots of 100 shares. We buy a put at a strike price of 45$ and pay 4 cents for it, i.t. 4$. If we subtract the $4 from $10 we get our final credit of $6.

The brokerage requires cash equal to the difference in strike prices of the puts in your account to execute this strategy. So in our example, the brokerage requires 5$/share or $500 for a hundred shares. This is because that is the maximum possible loss on this strategy, but we will get to that later.

Selling Put Spreads for Income

So for our investment of $500, we received a credit of $6. That is a return of 1.2%.

Benefits and Risks of Selling Put Spreads.

But in the next case, what happens if the stock price falls within the spread? In this case, your loss is the difference between the stock price and the upper strike price minus the premium received. This is pretty much the same risk as selling a put. Since it is possible that the sold put could get executed, spreads require that you have a margin account. If this happens, you would have to sell the shares that were assigned to you. You can also close the spread at a loss to prevent that assignment before it happens. We will talk more about that in a future blog post.

Selling Put Spreads for Income

But what happens if the stock price falls below both strikes? In this case, the bought put protects you from losses below its strike price. So put spreads have a defined risk that is lower than that of a sold put. In this case, the buyer of our sold put would execute the sold put and we would execute our bought put. So our maximum loss is $500. Under the hood both the puts would get executed so we would receive the shares for $50*100, i.e. $5000 and immediately hand them off for $45*100, i.e. $4500 so we would have our maximum loss of $500. However, we did get paid $6, so technically, our maximum loss is $494.

Selling Put Spreads for Income

While a put spread reduces your risk by protecting you from further downside compared to a sold put, if you exclusively rely on sold puts, you can risk your entire account. For example, if you had $5000 in your account and sold 10 such put spreads, and the stock fell below $45, you would lose all the $5000. It is very important to be diversified while using put spreads and BrokerBotics can help you do just that!

A Real Example

Let’s look at this real example of Nvidia stock. We can see the stock price is about $882. If you sell a put spread with the sold side at $875 and the bought side at $870, you would receive $16.35-$14.25 = $2.10 or $210. That’s a 42% return. ($210/$500). That is a massive return, however, Nvidia is a very volatile stock and you could end up in the maximum loss scenario. In this case, you would lose $500. But we did get paid $210, so our maximum loss is $290, i.e. 58%.

Selling Put Spreads for Income

On the other hand, you’d make a lower return if we look at a lower strike price like $785 bought and $790 sold, you would receive $17 ($1.08-0.91 = 0.17 or $17 for 100 shares). That’s a return of around 3.4% ($17/$500). While it’s significantly less than the other example, it is far less likely that the stock will move down that much in a week (for weekly options which is what is in this example), which means that option spread is much less risky.

Notice that compared to selling puts, put spreads require less capital while providing similar returns much further away from the stock price. This makes them a popular choice for income. Just be aware of the risks while deciding how much of our portfolio to assign to spreads.

If you do this weekly, even small returns like this can add up to significant returns in a year. We hope that the information provided has been of assistance in enhancing your understanding of options. At BrokerBotics, we automate such income-generating trades and allow you to select your own stocks and set your own criteria for weekly or monthly returns. Sign up Today!

Disclaimer: This blog post is for educational purposes only and does not constitute financial advice and we are not recommending any particular stocks or strategies.

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