What is a short put spread?
A short put spread is a type of options strategy. You are buying a put option and selling a put option at the same time, but at different prices. This costs money in the form of a debit, so your maximum loss is the value of the debit that paid to enter the trade.
Your maximum profit is the difference between the prices of the two options, minus the value of the debit. To break even on this position, the stock price must be below the price of the long put option by at least how much you paid to initiate this trade.
The closer the strike prices are to the underlying stock's price, the larger your debit, but there is a higher chance that it will finish in-the-money. The wider the spread between the long put and short put, the more premium you must pay, but your maximum potential profit will be higher.
When to use a short put spread strategy
A short put spread is appropriate to use when you think the price of an underlying asset will go down before the expiration date of its options. If you are especially confident in your belief, you can trade this strategy more aggressively by entering the spread via further out-of-the-money options.
How to manage a short put spread position
When trading a short put spread, the effect of time decay is on balance slightly positive. The option you sold will lose value, which is good. However, the option you bought will also lose value, which is not good.
Implied volatility can have different effects on your position depending on where the underlying stock is relative to your strike prices. If you think the stock price will go up beyond the option with the higher strike price, you want the implied volatility to decrease. This is because it will make both options less valuable, and a trader betting that the stock price will decline will want the options to expire worthless.
If you think the stock price might go down, you want the option with the lower strike to have a higher implied volatility. This will increase the value of the near-the-money you are holding faster than the option you sold, making the spread less valuable.
Short put spread maximum profit potential
When you set up a short put spread strategy, the potential profit is limited to the net credit you receive.
Short put spread maximum loss potential
The maximum loss you could face is limited to the difference between the lower and higher strike prices, minus the value of the credit you receive from the position.