Today I’m going to outline the
second option strategy with two legs: the Long Put Spread.
Long Put Spread
Structure
The Long Put Spread consists of two
legs; the Purchase of a Put option and the Sale of a Put option with the same expiration date and a lower strike price.
Application
A Long Put Spread is useful if you
anticipate a (small) decrease in the price of the underlying asset.
A Long Put Spread can be used in
three different ways:
 Defensive; both strike prices inthemoney;
 A consistent market price results in maximum profit upon expiration
 Offensive; highest strike price inthemoney, lowest strike price outofthemoney;
 A consistent market price results in profit upon expiration
 The price must drop to the lowest strike price for maximum profit upon expiration
 Aggressive; both strike prices outofthemoney;
 A consistent market price results in maximum loss upon expiration
 The market price must drop to the lowest strike price for maximum profit upon expiration
Investment
The investment amounts to the number
of contracts you trade x the contract size
x the price of the Long Put Spread (= Price of purchased Put minus the
price of the sold Put option). If you buy 10 Put options for 11.05 and you sell
10 Put options for 5.75 you pay a balance of 10 * 100 * (11.05 to 5.75) = 1.000
* 5.30 = 5.300 euros.
Margin
The Long Put Spread strategy has no
margin obligation.
BreakEven Point
You’ll reach the breakeven point upon
expiration if the price of the underlying asset is equal to the strike price of
the purchased Put option  /  the price you paid for the Long Put Spread.
Maximum Profit
The maximum profit in a Long Put
Spread is limited. Upon expiration, the maximum profit is equal to the strike
price of the sold Put option minus the exercise price of the purchased Put
option minus the price you paid for the Long Put Spread.
Maximum Loss
Your maximum loss is equal to your
investment. If the price of the underlying asset is equal to or higher than the
strike price of the purchased Put option upon maturity, then no intrinsic value
will remain for either Put option. The Put options will expire at 0 and you’ll
lose your investment.
Advantages
The advantage of the Long Put Spread
is that a small investment can realise a high return at consistent market prices
and / or small price decreases.
Disadvantages
The disadvantage of the Long Put
Spread is that if it expires at a price that is more than the highest strike
price then you’ll lose the entire investment.
Example (based on closing prices of
Monday 12th November):
The AEX lists 332.33 at this particular
moment in time. Suppose we buy a Put option on the AEXindex with a maturity of
one month and a strike price of 340.00 for a price of EUR 11.05. And we sell a
Put option on the AEXindex with the same expiration date and a lower strike
price of 330.00 for a price of EUR 5.75.
This Long Put Spread costs 5.30 (=
11.05  5.75).
One Long Put Spread requires an
investment of EUR 530 (=1 x 100 x (11.05  5.75) = 100 x 5.30).
The Long Put Spread has an intrinsic
value of 7.67 (= 340.00  332.33).
With this Long Put Spread you sell
for a balance of 7.67  5.30 = 2.37 time value. At a consistent market price,
this is accrued the more the maturity decreases.
At a consistent price you’ll realise
a profit of 2.37 (=+45%).
The AEX price must increase by 2.37
(from 332.33 to 334.70 = +0.7%) upon expiration, in order to breakeven.
Below 334.70 and you’ll realise a
profit using this strategy.
Below 330.00 (0.7%) upon expiration
and you’ll realise the maximum profit using this strategy. The maximum profit
is (340.00  330.00)  5.30 = 10.00  5.30 = 4.70 at an investment of 5.30 (=+89%).
Upon expiration your results are as
follows:
AEX Price

Long Put 340
Intrinsic

Short Put 330
Intrinsic

Long Put Spread
Intrinsic

Long Put Spread
Profit

Profit
In EUR

Comment

315,00

25,00

15,00

25,00 – 15,00

+4,70

+4.700

Max Profit

320,00

20,00

10,00

20,00 – 10,00

+4,70

+4.700

Max Profit

325,00

15,00

5,00

15,00 – 5,00

+4,70

+4.700

Max Profit

330,00

10,00

0,00

10,00 – 0,00

+4,70

+4.700

Max Profit

334,70

5,30

0,00

5,30 – 0,00

0,00

0

BreakEven

335,00

5,00

0,00

5,00 – 0,00

0,30

300

Max Loss

340,00

0,00

0,00

0,00 – 0,00

5,30

5.300

Max Loss

345,00

0,00

0,00

0,00 – 0,00

5,30

5.300

Max Loss

350,00

0,00

0,00

0,00 – 0,00

5,30

5.300

Max Loss

Long Put Spread Graphical
Simulation:
Pitfalls
The traditional pitfall for private
investors using Long Put Spreads is to purchase "aggressive"
outofthemoney Put Spreads, in the hope that the price of the underlying
asset falls sufficiently with time. Whilst the potential maximum yield is
extremely high, the investor may lose sight of the fact that if the price
remains constant then the entire investment evaporates.
Consider investing in more offensive
or defensive Long Put Spreads instead, which may offer less in terms of maximum
profit, but result in a much smaller loss (or even profit) at a consistent
underlying asset price.
Please refer to the above table for
sample calculations (upon expiration) of various Long Put Spreads on the AEX
with a maturity of one month:
 For an aggressive Long Put Spread 320310, the AEX must drop by 6.7% to 310 upon expiration for a maximum profit of 545% (8.45 as compared to 1.55).
 If the AEX lists more than 320 (3.7%) upon expiration then the loss will be 100%.
 Breakeven is reached at an AEX of 318.50 (4.2%).
 For a defensive Long Put Spread 350340, the AEX must rise by 2.3% to 340.00 upon expiration for a maximum profit of 27% (2.10 as compared to 7.90).
 If the AEX lists more than 350 (+5.3%) then the loss will be 100%.
 Breakeven is reached at an AEX of 342.10 (+2.9%).
Webinar "Smarter Investing with Investment Tools"
On Wednesday 14th November at 20:00,
the AEX College of NYSE Euronext in partnership with Finodex, will run a free
webinar. You can subscribe up until 19:30 on 14th November via: http://www.aex.nl/aexcollege/webinars/inschrijven.
Until then,
I wish you much success and plenty
of fun with your investments!
Herbert Robijn is founder and director of
FINODEX (www.finodex.com). FINODEX develops
innovative online investment tools for private equity and options investors.
These cuttingedge tools allow investors to make a comprehensive market
analysis, complex calculations and appropriate selections, at just the touch of
a button.