Put Spreads vs. Naked Puts

Buy Stock Below Currrent Market Value

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Profit/Lost Profile after Selling a Put Spread. © OptionsPlaybook.com

I received a series of questions from a brand new options trader.  My replies are in bold.

Mark,
I did a bull put spread- just 2 contracts.

Bought 2 XYZ Jul 38 P and Sold 2 XYZ July 40 P

This is the first put spread I have ever done. I’d like to make sure I understand it.
Understanding what you are doing is something to do before making the trade, but let's be certain that you understand NOW.

This lowers (limits) my potential loss on the spread to $2 per share if the stock plummets.

Yes (almost). The maximum value for that spread is $2. But don't forget to deduct the $0.38 premium collected when selling the spread: Your potential loss is 'only' $1.62 plus commissions. Selling a spread is a good way to practice risk management.

I sold the 40 puts, so if the stock falls below 40 I am obligated to buy it. It is a bullish trade, so I am believing the stock will be above 40 on the expiration date.
Yes.

If the stock is above 40 at expiration the puts expire worthless and I keep the credit I received (net credit 38 cents per share).
Yes. That cash is already in your account. And it is yours to keep NO MATTER WHAT HAPPENS.

If the stock is between 38 and 40 the 38s will expire worthless and I will be on the 40 puts. That is fine, I am getting it at a reduced price and I like owning the stock.  But, CAN I SELL TO CLOSE THE 38s?
 (a) True, you are getting the stock at a reduced price (compared with the current price). The price reduction is 38 cent, or the credit collected earlier. In this scenario, you would own stock at $39.62, plus commissions.

 (b) You may try to sell the 38s at any time before the market closes on expiration day that 3rd Friday. However, the options may be worthless by the time you decide to sell them and there will be no bids for that option.

(c) Be very careful. You sold the put spread and thus, bought the 38 puts for protection, not as a profit source. Thus, if you sell the 38 puts prior to expiration, you are losing that protection. If your plan is to unload that protection, are you certain that you want to buy these puts in the first place? Perhaps you should just sell naked puts?

What is the best strategy?
'Best strategy' is impossible define because it varies from trader to trader. The vast majority of put spread traders have no interest in owning stock. They trade spreads with the intention of earning a short-term profit. There is seldom an interest in owning shares. However, there is nothing wrong with buying stock at $39.62 and establishing a stop loss at $38. If the stock is below $38 at expiration, you would exercise your put and dump the shares at $38, limiting your loss.

This is very different from the mindset of traders who are willing to own stock. They sell naked put options. Thus, the question remains: why did you buy the 38 puts? Buying them was neither 'right' nor 'wrong.' But it depends on your rationale for making the trade: Short-term trading profit vs. a desire to buy the shares at a discount.

The reply, with more questions, arrived via e-mail:
This is a bit of a hybrid. Given that I am willing to own stock, doesn't owning the 38 puts provide some protection? Also, if the stock is below 38 near expiration, the 38 puts have value and I could sell them, thus reducing my cost basis for buying the stock?

Yes. You are correct. Owning the puts provides protection. But that protection is NOT cheap.

Yes again. Selling those puts reduces the cost basis. However, not buying the puts in the first place also lowers your cost basis.

Traders who sell naked puts - don't seek only that short-term trading profit. They are willing to own the shares at a better price (when compared with the stock price at the time the puts were sold) - and almost never buy protection.

You are doing both. You want to own the shares and you prefer to own protection. There is nothing wrong with that. I believe it is always a good idea to limit losses. However, you are new to options and I want to be certain that you recognize that the cost of owning puts as protection is relatively expensive -- and severely hurts future profits. Then there is this question: What are you going to do for protection (if you do buy stock) after July expiration? Your 38 puts will have expired worthless. Will you continue to spend more money on protection? That makes it difficult to earn money.

NOTE: When you own stock plus puts, that is equivalent to owning calls - with the same strike and expiry as the puts. Do you truly want to own calls rather than stock? I cannot answer for you.