Hey everyone. This is Kirk here again at Option Alpha and in this video, I want to walk through a bull put spread risk calculation to figure out how much risk you have in the position. Again, this is also referred to as a put credit spread since you’re selling options net and taking in a credit or referred to as a short put spread. There’s a lot of different names that people can give this, but ultimately, it’s all the same stuff. And it’s really important that we go through this and understand exactly how to calculate these breakeven points because they’re really important in understanding the risk that’s associated with the positions that you’re trading. Here is the structure of a payoff diagram. And remember, a bull put spread’s payoff diagram looks like the following where it has these two pivot points that it shifts and it pivots on the graph. These two points are the points at which you buy or sell different option contracts. In our example, we’re going to look at one where we sell a put option, so we’re going to be –1 put option here at a strike price of $75, and then we’re going to buy a put option down here, so +1, buy a put option at a strike price of $70.
Now, this is a classic bull put spread where you’re just simply selling a put option, buying a put option at a lower strike price to give yourself defined profit and defined risk, and what we’re trying to figure out is what is this risk amount, how much are we really risking on this position. The first thing that we have to do to calculate that is we have to figure out the width of the spread. Now, in our example, this part is pretty easy. The width of the spread or the difference between the two strike prices here is simply $5, and that $5 point becomes very important because it is the starting basis for understanding how much risk we have in each of the spreads that we sell. Now, the reason it’s $5 is because if we get to expiration and we have to deal with assignment of contracts, we would lose the difference between these two contract prices or strike prices and that would be the $5 that we’d lose for each of those particular shares. That’s why the risk in this position starts calculating with this $5 premium in mind. Now, again, we know that obviously, we did not just enter this position and have all this risk and no upside potential. Clearly, we see that we have some upside potential here, right? And so, now, what we have to do is we have to take this $5 total spread width and we subtract the net credit that we collected from the individual contracts that we had sold. Let’s assume, for the sake of argument, that we had sold this one put option at a 75 strike and we had sold that for a $3.10 premium, so essentially, we collected a $3.10 premium for that individual leg. On the put side, on the 70 strike, if we had bought this put option, so we are now long a put option, it would’ve cost us money, and let’s assume that it cost us $2.18 to buy that particular contract. Again, we sold the 75 strike put for $3.10, we use some of the proceeds to buy the 70 strike put for $2.18, so the net difference between these two prices, the total credit that we collected on this particular position was simply a $.92 premium. That $.92 premium actually ends up being our max profit as well. It’s actually really easy to see that the $.92 premium we collected here also turns out to be our max potential profit. If the stock closes anywhere above 75, we make the full $.92 premium.
But now, we actually can complete our formula here and we can determine how much risk is actually in this position after we factor in the credit that we received on trade entry, and in this case, the total risk that we still have left over in the position is $4.08. $4.08 is how much we actually have to put up in margin or how much we’re risking if the stock goes the other direction and goes lower, closes well beyond our 70 strike put option that we purchased here. That’s how much we’d be risking. To complete the formula, we basically have $4.08 here as far as risk, we’ve got $.92 of potential profit premium, and a good way to double check your math is just simply to add the risk and the profit potential back together and that should equal the $5 spread width. If we take the $4.08 and we add this to the $.92 that we have here, you can see that that does give us truly that $5 premium and that is the difference between the strike prices, so we know that this whole formula and this calculation balances out. Again, it’s really important that we understand how much risk we’re taking on just one simple spread like this because if we end up trading more contracts, let’s say we’re trading six of these bull put spreads where instead of selling one, we sell six, and instead of buying one, we buy six here, we’re doing a lot of different contracts, now, what we have to do is we have to take six contracts times the $4.08 that we have here as far as risk per spread that we’re selling and that gives us a total risk of $24.48 which again, remember, with option contracts, this is not $24.48, this is $2,448 of total risk, and this is why it’s so important to make these calculations and to do that, and even do them by hand just like we’ve done here on a scratch piece of paper, so that you understand how to calculate risk and how to use this number as a means to control position sizing and allocation in your account. As always, if you guys have any questions on this or anything else options related, please let us know and until next time, happy trading.
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