A vertical put spread is plain vanilla strategy that can be initiated as a hedge or to make an outright bearish bet on the underlying stock, ETF, index, or futures contract. An example surfaced today in the iShares Australia Fund (EWA) and I’ll highlight the trade as an example of this 101 strategy. — sometimes called the bear put spread.
EWA is off 21 cents to $21.28 and an Oct 18 – 20 put spread trades on the ETF for 65 cents, 3125X, to open. In this strategy, the investor apparently bought 3125 October 20 puts on the the fund for $1.31 and sold 3150 October 20 puts at 66 cents. EWA shares are up 4.4 percent since Jun 4, when the ETF was probing an established support area around $20 per share. On June 5, EWA benefitted from news of a rate cut from Australia’s central bank and, on June 6, was also helped by data that showed Australia’s economy growing twice more than expected.
The October 18 – 20 put spread on EWA probably reflects the view that the recent rally won’t last, the support area won’t hold, and shares will be trading south of $18 (~15.4%) through the October expiration. The best possible gain from a bear put spread is equal to the difference between the two strike prices, minus the debit, and happens if shares are trading at the lower strike or less a the expiration. At that point, the spread is equal to 2 and the profit is 2 minus .65, or $1.35. So, the investor is risking .65 to make 1.35, a ratio of about two-to-one. The debit is at risk if shares hold above the $20 strike (~5.9%) and the position is left open through the expiration. However, the spread can be offset (sold-to-close) at any time prior to expiration. The breakeven at the expiry is equal to the higher strike, minus the debit. In this case, the spread breaks even at 19.35.
The vertical put spread is a limited risk-reward strategy that can be used to hedge a stock position or make outright bearish bets on the underlying. The deeper out-of-the-money the spread, the greater the potential risk-reward and the lower probability of success. It’s a strategy that we see initiated relatively often in today’s volatile markets.
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Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.