A bull put spread is a variant on the popular put writing technique in which an options investor writes a put on a company in order to receive premium income and maybe acquire the shares at a discount. A significant danger of put writing is that the investor is compelled to purchase the stock at the put strike price, even if the stock falls much below the strike price, resulting in an immediate and significant loss for the investment. A bull put spread mitigates the inherent risk of put writing by concurrently purchasing a put at a lower price, lowering both the net premium earned and the risk of the short put position.
Which Vertical Option Spread Should You Use?
Bull Put Spread Definition
A bull put spread includes writing or short selling a put option and concurrently acquiring another put option with the same expiry date but a lower strike price (on the same underlying asset). A bull put spread is one of four fundamental forms of vertical spreads, along with the bull call spread, bear call spread, and bear put spread. The premium obtained for the short put leg of a bull put spread is always greater than the premium received for the long put, implying that this method requires an initial payment or credit. As a result, a bull put spread is also known as a credit (put) spread or a short put spread.
Profiting from a Bull Put Spread
In the following scenarios, a bull put spread should be considered:
- To generate premium income: This approach is suitable when the trader or investor wants to earn premium revenue while taking on less risk than just writing puts.
- To purchase a stock at a cheaper price: A bull put spread is a smart approach to purchase a chosen stock at a lower effective price than its current market price.
- To profit from sideways to slightly higher markets: Put writing and bull put spreads are ideal strategies for markets and equities going sideways to slightly higher. In such situations, other bullish methods, such as purchasing calls or establishing bull call spreads, would be ineffective.
- To make money in volatile markets: Put writing is a dangerous business when markets are volatile because to the increased risk of being given equities at excessively high prices. By limiting downside risk, a bull put spread may allow options to be written even in such conditions.
Bulldozers Inc., a fictitious company, is trading at $100. An option trader anticipates that it will trade up to $103 in one month, and although she would want to write puts on the stock, she is worried about the possible negative risk. As a result, the trader writes three contracts of the $100 options, which are trading at $3 and expire in one month, and concurrently buys three contracts of the $97 puts, which are trading at $1 and also expire in one month.
Because each option contract represents 100 shares, the net premium income of an option trader is:
($3 x 100 x 3) – ($1 x 100 x 3) = $600
(For the purpose of simplicity, commissions are not included in the calculations below.)
Consider the following situations in the closing minutes of trade on the option expiry date a month from now:
Scenario 1: Bulldozers Inc. is trading at $102.
The $100 and $97 puts are both out of the money and will expire worthless in this situation.
As a result, the trader receives the whole $600 net premium (less commissions).
The best case scenario for a bull put spread is when the stock moves above the strike price of the short put leg.
Scenario 2: Bulldozers Inc. is trading at $98.
The $100 put is in the money by $2 in this scenario, whereas the $97 put is out of the money and so worthless.
As a result, the trader has two options: (a) close the short put leg at $2, or (b) purchase the stock for $98 to meet the obligation resulting from the short put exercise.
The former option is better since the latter would result in more commissions.
Closing the short put leg at $2 would require a $600 investment ($2 x 3 contracts x 100 shares each contract). The total return is zero since the trader earned a net credit of $600 when he initiated the bull put spread.
As a result, the trader makes a profit but is out of pocket to the amount of the commissions paid.
Scenario 3: Bulldozers Inc. is trading at $93.
In this scenario, the $100 put is profitable by $7, while the $97 put is profitable by $4.
This position’s loss is consequently [($7 – $4) times 3 x 100] = $900.
However, since the trader got $600 for opening the bull put spread, the net loss is $600 – $900.
= -$300 (plus commissions).
To summarize, the following are the essential calculations related with a bull put spread:
Maximum loss = difference between put strike prices (i.e. short put strike price less long put strike price) – net premium or credit received + fees paid
Net premium or credit received minus commissions paid = maximum gain
When the stock moves below the strike price of the long put, the maximum loss happens. When the stock moves above the strike price of the short put, the maximum profit is realized.
Breakeven = short put strike price less net premium or credit received
The breakeven threshold in the above example is $100 – $2 = $98.
Advantages of a Bull Put Spread
- The risk is restricted to the difference in strike prices between the short and long put options. This suggests that the position is unlikely to result in huge losses, as would be the case with puts placed on a falling stock or market.
- The bull put spread capitalizes on time decay, which is a powerful aspect in option strategy. Because most options expire or are not exercised, the odds favor a put writer or bull put spread creator.
- The bull put spread may be customized to a person’s risk tolerance. A more cautious trader may choose a tight spread where the put strike prices are close together, since this reduces both the maximum risk and the maximum possible gain of the position. An aggressive trader may favor a wider spread to increase profits, even if it means taking a larger loss if the stock falls.
- A bull put spread has fewer margin requirements than a put write since it is a spread strategy.
Disadvantages of a Bull Put Spread
- Gains are restricted with this option strategy and may not be sufficient to warrant the risk of loss if the approach fails.
- The short put leg is at high risk of assignment before expiry, particularly if the stock falls. As a consequence, the trader may be obliged to pay a price well in excess of the current market price for a stock. This risk is increased if the strike prices of the short put and long put in the bull put spread vary significantly.
- As previously stated, a bull put spread works best in markets that are moving sideways to moderately higher, implying that the ideal market circumstances for this strategy are fairly restricted. If the market rises, the trader is better off purchasing calls or utilizing a bull call spread; if the market falls, the bull put spread method is often unprofitable.
The Bottom Line
The bull put spread is an excellent option strategy for earning premium income or purchasing equities at below-market prices. However, although this technique has a low risk, it also has a low potential for profit, which may limit its appeal to very skilled investors and traders.
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