What Happens to Your Spread When the Underlying Hits Bull's-Eye Between Your Strikes?

optionsguy posted on 08/30/11 at 11:01 AM

TradeKing Sr. Options Analyst Brian Overby fields an option trader's real-world question: what happens to your spread when the underlying falls in the middle of your two strike prices?

I got this question recently from a TradeKing client named Eli, who writes:

Hello Brian, I've been reading on this site about selling call and put spreads, and I have a question. What happens when the underlying falls in the middle of the sold and bought put? For instance: Stock XYZ is currently at $100 and I sell the 80/75 put spread. Let's say the stock drops to $77. Since my bought put is out of the money, so no help, am I basically in a naked put position? What happens next? Thank you for your time!! - Eli

Hello Eli,

Yours is a common question about spreads, so let's quickly recap the scenario, then answer your question. 

1) You are short the following put spread on underlying stock XYZ:

Sold to open one 80 XYZ put
Bought to open one 75 XYZ put

You want XYZ to finish at or above 80 at expiration, so both options will expire worthless and you get to keep the net credit you received when setting up the trade - that's your max potential profit, too. (You'd deduct commissions from that too, of course. TradeKing commission for a 1-contract spread like this would be $6.25 to enter the position and that charge again to exit.) Max potential loss on a short put spread is limited to the difference between the strikes (5), minus the net credit received. 

2) Next, at expiration the underlying stock stops at 77.

Now the 80 put you sold is in the money, but the 75 put you bought is not.

3) Your question is: what happens now? There are a few possible scenarios. 

If an option is one cent in the money on expiration the Options Clearing Corporation will exercise on your behalf. This means the stock would be "put" to you, which means you will be buying 100 shares of stock at 80. Now at this point it would not make sense for you to exercise the 75 put and sell the 100 shares at 75 when the market is currently at 77. So the long 75 put you will let expire worthless and on Monday morning you would see 100 shares in the account and hopefully you had the money to pay for it and the market for the stock has not opened down. You no longer are "protected" by the long 75 put at that point, and you have all the risk associated with owning long stock. 

Another possible scenario: TradeKing closes the short put before the market closes on the expiration date. TradeKing's risk department might do this if you DO NOT have the cash to buy 100 shares at 80. If that is the case TradeKing reserves the right to close the put out on the open market, so you do not have the market risk of long stock on Monday morning. Disclaimer: I did say might do this - nothing is ever guaranteed in this situation. 

The best scenario, of course, is when you decide what to do. TradeKing and the Options Clearing Corporation never want to try to guess what you are thinking. So if a situation like this arises and you "may" be put stock that you can't pay for, we all want you to do something to take care of the position in advance. We never want to make a decision for any client, but sometimes our hands are forced. 


Hope this helps!


Brian Overby 
TradeKing's Options Guy 

[image: Bulls-eye by incase on Flickr]

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Posted by optionsguy on 08/30/11 at 11:01 AM


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