What it is
You buy a put and sell a cheaper put at a lower strike, same expiry. What the lower put brings in reduces what the upper one costs. Also called a bear put spread, since it is paid by a decline.
The lower put sets the limit on the payoff. Once the stock is under it, the two puts gain and lose in step, so the profit tops out at the distance between strikes less the net debit. The debit itself is the most the position can lose.
What has to happen for it to make money
The stock has to drop below the upper strike less the net debit. At or under the lower strike the spread pays its full width. Above the upper strike both puts are worthless at expiry and the debit is gone.
It suits a fall of a particular size, since a crash pays it no more than a decline to the lower strike. Time works against it, more gently than against a single put, and a jump in volatility helps it less, because the sold put offsets part of each.
Once it is on
As protection for shares, it is a cheaper kind of insurance that covers a band of the fall rather than all of it: from the upper strike down to the lower, and nothing below. As a bet, the usual plan is to close once the stock has reached the lower strike rather than wait for the last of the time value to drain from the sold put.
What goes wrong
The stock holds up. Above the upper strike at expiry, the whole debit is lost, cycle after cycle if it is bought as standing protection.
A crash past the lower strike. The spread pays its maximum and no more, so as insurance it leaves everything below the lower strike uncovered, which is exactly the part of a fall that does the most damage.
Pros and cons
- Pro: a cheaper way to be paid by a fall than a lone put.
- Pro: the cost, and so the risk, is fixed at the open.
- Pro: time decay costs it less than a single put.
- Con: nothing more is earned below the lower strike.
- Con: as insurance it covers a band, not the tail.
- Con: two legs, and a larger share of the trade lost to costs.
In Restrike
The two puts fold into one position on the Log and the Portfolio, with the outcome stated against its maximum and the required win rate set beside the actual one. Restrike imports it read-only from your broker and never places a trade.