Credit spreads: buying a floor with part of the premium

A short put has a known maximum gain and an enormous maximum loss. A credit spread fixes the second number by adding a second option. You sell a put, and you buy a further out-of-the-money put on the same stock and expiration. The one you sold is the trade; the one you bought is the insurance. The difference between what you collect and what you pay is the credit.

The numbers

Stock at $100. Sell the $95 put for $2.00, buy the $90 put for $0.80. Net credit: $1.20, or $120 per spread.

	Per share	Per spread
Credit received	$1.20	$120
Maximum loss (width minus credit)	$3.80	$380
Breakeven	$93.80
Collateral required	$3.80	$380

Below $90 the long put gains a dollar for every dollar the short put loses, so the position stops losing. The worst case is $380, and it's the worst case at $89, at $60, and at zero.

What the protection costs

Three things. The $0.80 you paid for the long put is 40% of the premium you collected. The breakeven moved up, from $93.00 for the naked put to $93.80, so you lose money in a slightly wider band. And you paid the bid-ask spread on two options instead of one, which on a thin name can be a meaningful fraction of the credit.

In exchange, the collateral fell from $9,500 cash-secured, or a couple of thousand on margin, to $380. The return on capital, $120 on $380, is about 32% for the life of the trade. That number is why spreads are popular and why they're dangerous: it invites selling ten spreads where you'd have sold one put, at which point the "defined risk" is $3,800 and the loss arrives just as often.

Where the cap helps and where it doesn't

For a moderate drop, the spread loses slightly more than the naked put, because the $0.80 of protection hasn't done anything yet. At $92, the naked $95 put is down $100 after its $200 premium; the spread is down $180. Below the long strike the picture reverses: at $80 the naked put is down $1,300 and the spread is still down $380. The spread buys protection against the crash, not the dip. If the bad outcome you actually expect is a 7% pullback rather than a 40% collapse, you're paying for a cap that won't be reached.

Assignment with two legs

If the short put is assigned early, you own 100 shares at $95 and still hold the $90 put. You can exercise it to sell the shares at $90, or sell the shares and the put separately, usually for slightly more. Either way the loss is capped as designed. The problem case is expiration: the stock closes at $92, the short $95 put is assigned, and the long $90 put expires worthless. Saturday morning you own 100 shares bought at $95 with no protection, and the weekend's move is yours. Close spreads before the last hour whenever the stock is between the strikes.

Calls, and the same shape twice

A call credit spread is the mirror: sell a call, buy a higher one. Same math, opposite direction. Selling a put spread and a call spread together makes an iron condor, which collects two credits against one collateral requirement and loses on a big move in either direction.

What the spread doesn't fix

It fixes the size of the loss. It doesn't change the probability of one, and it doesn't make a bad strike a good one. A spread is a short put with a floor. Treat the short strike with the care you'd give it naked, and treat the maximum loss as a number you actually expect to hit now and then.