Short Put Spread
Outlook: Neutral to bullish

The short put spread -- or "bull put spread," as it's also described -- is a relatively conservative option strategy, since the profit potential is strictly capped. In execution, it bears a strong resemblance to the short put, though the addition of another purchased put option curbs the possible risk rather substantially. So, if you're the type of trader who's drawn to the short put strategy but is turned off by the lopsided risk/reward ratio, the short put spread might be a winning alternative.

Let's examine how this trade works by looking at an example.

Entering the Trade

Stock XYZ is comfortably poised above support at the $40 level, and you expect the shares to continue holding steady above this technical floor during the foreseeable future. To take advantage, you decide to initiate a short put spread by selling to open XYZ's 40-strike put, and simultaneously buying to open a 38-strike put in the same series.

The 40 put is bid at 0.57, and the 38 put is asked at 0.12. Subtracting the cost to buy the long put from the premium you collected selling the short put, your net credit is 0.45. Multiplied by 100 shares per contract, you'll rake in $45 at the initiation of the trade. (Since a short put spread is always initiated for a net credit, it falls under the category of "credit spreads.")

Potential Gains

Your initial net credit of $45 is the most you stand to make on the trade. If XYZ closes anywhere at or above $40 per share upon expiration, both puts can be left to expire worthless, and you'll walk away with that cash in your pocket.

Breakeven is calculated by subtracting your net credit from the sold strike. In this case, that's $39.55 (40 - 0.45) -- which means you can theoretically eke out a profit as long as XYZ closes at $39.56 or higher. However, if XYZ falls below the strike price of your sold put, you'll have to buy (to close) the option -- and the additional transaction cost could eat up any remaining profits.

Potential Losses

The potential loss on this spread is greater than the potential reward, but -- as noted earlier -- it's still a much more attractive scenario than if you had simply written a lone put. The maximum loss is equal to the difference between the two put strikes, less the net credit. In this case, that's (40 - 38) - 0.45 = 1.55. Multiplied by 100 shares per contract, you could be out $155 if XYZ falls to $38 or below by expiration.

Volatility Impact

Typically, a put seller would like to see implied volatility fall, since it will lower the cost of the option in the event it should need to be repurchased. However, in strategies combining sold and bought options, the overall impact of implied volatility is somewhat muted.

Other Considerations

While the profit potential on a short put spread isn't exactly staggering, this trade holds some appeal as a "cash-collecting" strategy. The spread allows the investor to profit whether the stock moves sideways, slightly higher, or sharply higher during the time frame of the trade -- as opposed to a call-buying strategy, which necessitates a significant move higher in order to offset the inevitable loss of time value.

As with many other strategies that center around premium selling, it makes sense to focus on near-term options for a short put spread. This affords the stock less time to make a sudden, unexpected move against you.