The bull put spread is a complex bullish option strategy despite having just two transactions. It requires high options trading skill so this strategy is not meant for the beginners. It profits when the price of the underlying stock rises and typically used when the expectation is for a small increase in price.
It is a good alternative for selling a put option if we don’t want to be exposed to unlimited loss. This strategy involves buying and selling a put which directly limits our loss. It also reduces the profit potential. The bull put spread is an alternative choice to the bull call spread. It’s best executed when the outlook of the market is ‘moderately bullish’ to flat. The result of Bull put spread is a net credit.
As we already know, options are derivations from its underlying asset. If we wanted to create a bull put spread of a particular asset, that means we expect the asset to hold or move upwards for the period of validity of that put spread. Usually, this strategy is applied as a complimentary return. Sometimes, a stock has periods when the price doesn’t move much, therefore this means almost no returns on the investment. Selling puts is a nice way to collect money that adds to the overall return of the buy and hold asset strategy.
Constructing a bull put spread
Creating a bull spread strategy, requiring two simultaneous transactions, is relatively easy. To do it we sell puts “at” or “in” the money, and buy the same amount of puts of the same security at an out-of-the-money strike price. This way, the puts we sell have a higher strike price (and value) than those we buy. Since the puts sold have a higher premium than the ones bought, we create a net credit. The options that we buy and write (sold) should have the same expiration date, preferably a near time expiry.
As a general rule, we should write at the money (ATM) puts and purchase out of the money (OTM) puts. To increase profit potential we could go for selling in the money (ITM) puts. In this case, we expect the price of the underlying stock to go up beyond the strike price of the sold puts. Basically, the greater the difference the two strike prices the more profit potential as well as attracting higher loss in case the trade goes wrong.
Maximum profit and loss
Ideally while implementing this strategy we expect that the put contracts sold to end out of the money (OTM) by the expiration. If that happens, the net credit already received is all we get (because the purchased put contracts end worthless too since they will be even farther out of the money). Whereas if we write at the money (ATM) contracts, we will make a higher profit than the previous case provided the stock doesn’t go down. What we also need is the price of the underlying stock to increase to at least the strike price of the sold contract.
The strategy will be in a losing position if the stock price falls in price. Which means the puts sold will expire in the money where they will be exercised and we need to buy back the contract at the market price.
The maximum loss would be incurred if the price of the underlying stock fell to the strike price of the bought put contracts. If it falls lower than that then we would exercise the puts which were bought and close all the positions. Therefore, the maximum loss is only the difference between the two strike prices.
Example of Bull Put spread
Let’s say IBM is trading at $110 a share. Now a bull put spread is carried out by selling one 100 put at $3.2 and buying one 95 put at $1.3. The net credit received is $1.9. The difference between the bought and sold options is $5.0. The maximum risk, therefore, is $5.0-$1.9=$3.1. This maximum risk is applicable if the stock price is at or below the strike price of purchased put.
Break-even point: Strike price of sold put – net premium received.
Here: $100 – $1.9 = $98.1
Profit/Loss diagram and table:
Impact of Volatility
Volatility is a measure of the change in the stock price over a period of time in percentage terms and it determines the option prices. Since a bull put spread involves two options transactions, the profit variation due to change in volatility is very little keeping other factors constant. In the options market, this is referred to as “non-zero vega”. Vega is nothing but how much an option price changes as a measure of the change in volatility and other factors remaining constant.
Impact of Time
The time value of an option decreases when the option nears the expiry. This is known as time erosion. In case of a bull put spread if the stock price is in the neighbourhood of the short put strike then the price of spread decreases with the passage of time. This is because the short put is closest to the money and erodes faster than the bought put. However, if the stock price is below the long put then price of spread increases over time. This is because the bought put is near the money and erodes faster than sold put. If the stock price is in the middle of the two strike prices then the time erosion has very little effect on the price of a bull put spread as both the options would expire at the same rate.
The bull put spread is an excellent options strategy for anyone who is looking to make a quick profit from a small rise in the price of a security.
Both profit and loss are limited in this strategy and is also a suitable strategy if we believe that the stock could fall in the coming weeks.
One of the drawbacks of this strategy is that it requires a fair amount of margin, meaning you will have to provide capital to the broker.
Another drawback is incurring additional commissions if you want to close all your positions. Since it requires high skill and experience, it is advised for beginners not try this strategy right away and practice on a demo account.