The value of a long put vertical spread can appreciate as the price of the stock or ETF drops and approaches the long strike price and, ideally, past the short put’s strike price. The ideal scenario is when the stock price drops below the short put strike at expiration to appreciate its maximum value, which is its spread width.
Conversely, the value of the long put vertical spread can depreciate when the price of the underlying it tracks rises. Additionally, due to time decay, the value of the spread can depreciate over time if the underlying price remains constant and does not approach or drop below the long put's strike price.
Unlike buying a single put option outright, a long put vertical spread allows you to reduce your overall cost to deploy the bearish strategy. Due to the lowered cost, the max loss is less than buying the put outright. However, the max profit of the strategy is capped because of selling a further out-of-the-money put against the long put.
Investors can close or sell the long put spread for a higher amount than what the trader paid for it to book a profit before expiration or sold for less than the debit paid up front to minimize the max loss. In other words, the trade does not have to be held to expiration to yield a profit or loss potentially.
Expiration Risk for Long Put Vertical Spreads
A defined-risk vertical spread is no longer a defined risk position if one leg of the spread expires in the money and the other does not. The risk lies with pin risk on the day of expiration, which is the risk surrounding the uncertainty of where the underlying will close to determine whether an option is in or out of the money. Options that expire in the money by $0.01 or more are auto-exercised, resulting in the long put option converting to 100 short shares of stock. In the case of a long put vertical spread, a partially ITM spread will convert to 100 short shares, and the OTM short put option would not get assigned to offset the short shares [with long shares]. When you end up with short shares, the risk is unlimited to the upside, so manage accordingly.
Additionally, any options strategy involving short options, including a long put vertical, may face after-hours risk on the day of expiration. In summary, although the vertical may have expired OTM based on the stock's closing print, an OTM short put option can become ITM based on any extreme downward price movement after the market close, resulting in an unexpected assignment of long shares. As a result, the investor would assume the risk of 100 long shares per contract assigned. The only way to eliminate after-hours risk is by closing any short options positions before expiration.
Due to the risk of exercise and assignment, it's crucial to have a plan and manage risk like closing or rolling the position before expiration, especially when the account does not have sufficient account equity to take on the resulting position. Please visit the Help Center to learn more about Expiration Risk.
