A defined risk spread is a strategy that caps your maximum loss potential. Max loss occurs when the underlying falls and breaches both legs of the short put vertical spread, causing both legs to go in-the-money (ITM) and trade at its full value, which is its spread width. When preparing a short put vertical spread order, you know what is at risk at order entry.
Compared to a short put on its own, one characteristic of a short put vertical is that the overall credit received is lower because it requires a long put to make it a defined risk. In other words, you must pay for protection.
However, a potential benefit of a defined-risk spread is that it requires a lower buying power requirement since we know the max loss ahead of time, which can be more capital efficient for accounts with limited buying power.
Like any other short options strategy, you will initially receive a credit when selling a put vertical spread. The value of the put spread will decrease when the underlying rises in price, which is the exactly what you want for your short put vertical spread to be profitable to keep the credit.
Additionally, the value of a short put vertical spread can decrease over time when the price of the underlying remains constant, and the spread remains OTM due to time decay. The ideal scenario for a short put vertical spread is that it remains OTM, above the short put strike, at expiration, expires worthless, and yields a max profit which is the credit received on trade entry, less commissions and fees. The trade can also be “bought back” (covered) for less than the credit received upfront to yield a profit or bought back for more than the credit received upfront to realize a loss. In other words, the trade does not need to be held to expiration.
Conversely, the max loss scenario for a short put vertical spread is that it moves in-the-money (ITM). This happens if the stock price falls and trades below the long put strike. The spread can trade for a maximum value of the distance between the strikes, and the trader would have to buy back the spread to close the trade. At expiration, max loss would be realized in this case, or the trader can buy back the spread for potentially less than max loss before expiration if they choose to exit the position.
Expiration Risk for Short 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 short put option converting to 100 long shares of stock. In the case of a short put vertical spread, a partially ITM spread will convert to 100 long shares through short put assignment, and the OTM long put option would not get auto-exercised to offset the long shares [with short shares].
Additionally, any options strategy involving short options, including a short 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 getting assigned long shares, it's crucial to have a plan, like closing or rolling the position before expiration, to avoid this particular assignment risk, 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.
