Knowledge is Having the Right Answer

Bull Put Spread Strategy and Example

What Is a Bull Put Spread?

Bull Put SpreadA bull put spread is an options trading strategy.  Investors use it when they expect a moderate rise in the price of the underlying asset. The strategy employs two put options to form a range.  One sets the high strike price and the other, a low strike price. The investor aims to receive a net credit from the difference between the two premiums from the options.  The maximum loss is equal to the difference between the strike prices and the net credit received.  The maximum profit occurs if the stock’s price closes above the higher strike price at expiry.

Investors typically use put options to profit from modest declines in a stock’s price.  A put option gives them the ability, but not the obligation to sell a stock on or before the expiration date of the contract. Each put option has a strike price, which is the price at which the option converts to the underlying stock. Investors pay a premium to purchase a put option.

The Bull Put Spread – A Deeper Look

A bull put spread uses two put options to form a spread.  It involves being short a put option and long another put option.  Both have the same expiration but one has a lower strike. The short put generates income from the premium associated with writing the option.  The long put’s main purpose is to act as a hedge.  It offsets assignment risk and protects the investor in case of a sharp move downward. Because of the relationship between the two strike prices, the investor will always receive a premium (credit) when initiating this position. This strategy entails carefully controlled risk and reward potential. The most this spread can earn is the net premium received at the outset.  This is most likely to occurs if the stock price stays steady or rises modestly.

However, if the stock declines instead, the strategy leaves the investor with a lower profit or even a loss. But, the maximum loss is capped by the long put. It is interesting to compare this strategy to the bull call spread. The profit/loss payoff profiles are exactly the same, once adjusted for the net cost to carry. The chief difference is the timing of the cash flows and the potential for early assignment. (Source: investopedia)

Construction of the Bull Put Spread

A bull put spread consists of two put options. First, an investor buys a put option and pays a premium. Next, the investor sells a second put option at a strike price higher than the one they purchased.  However, this time the investor receives a premium. Both options have the same expiration date.  The premium earned from selling the higher-strike put exceeds the price paid for the lower-strike put. At the onset of the trade, the investor receives the net difference of the premiums from the two put options.

  • Buyers – Investors typically buy put options when they are bearish on a stock.  This means they hope the stock will fall below the option’s strike price. However, the bull put spread is designed to benefit from a stock’s rise. If the stock trades above the strike at expiry, the put option expires worthless.  This is because no one would sell the stock at a strike lower than the market price. As a result, the investor who bought the put loses the value of the premium they paid.
  • Sellers – On the other hand, an investor who sells a put option is hoping the stock doesn’t decrease but rises above the strike so the put option expires worthless. A put option seller—the option writer—receives the premium for selling the option initially and wants to keep that sum. However, if the stock declines below the strike, the put seller is on the hook. The option holder has a profit and will exercise their rights, selling their shares at the higher strike price. In other words, the put option is exercised against the seller.

(Source: ibid)

Bull Put Spread – Profit and Loss

Both the potential profit and loss for this strategy are very limited and very well-defined. The initial net credit is the most the investor can hope to make with the strategy. Profits at expiration start to erode if the stock is below the higher (short put) strike, and losses reach their maximum if the stock falls to, or beyond, the lower (long put) strike. Below the lower strike price, profits from exercising the long put completely offset further losses on the short put.

Potential profit is limited to the net premium received minus commissions.  The potential loss is limited if the stock price falls below the strike price of the long put.  The way in which the investor selects the two strike prices determines the maximum income potential and maximum risk. By selecting a higher short put strike and/or a lower long put strike, the investor can increase the initial net premium income.

Maximum Loss

The maximum loss is limited. The worst that can happen is for the stock price to be below the lower strike at expiration. In that case, the investor will be assigned on the short put, now deep-in-the-money, and will exercise their long put. The simultaneous exercise and assignment will mean buying the stock at the higher strike and selling it at the lower strike. The maximum loss is the difference between the strikes, less the credit received when putting on the position.

Maximum Gain

The maximum gain is limited. The best that can happen is for the stock to be above the higher strike price at expiration. In that case, both put options expire worthlessly, and the investor pockets the credit received when putting on the position.

The maximum profit for a bull put spread is equal to the difference between the amount received from the sold put and the amount paid for the purchased put. In other words, the net credit received initially is the maximum profit, which only happens if the stock’s price closes above the higher strike price at expiry.  The goal of the bull put spread strategy is realized when the price of the underlying moves or stays above the higher strike price. The result is the sold option expires worthless. The reason it expires worthless is that no one would want to exercise it and sell their shares at the strike price if it’s lower than the market price. (Source: ibid)

Bull Put Spread – Pros and Cons

Pros

  • Investors can earn income from the net credit paid at the onset of the strategy.
  • The maximum loss on the strategy is capped and known upfront.

Cons

  • The risk of loss, at its maximum, is the difference between the strike prices and the net credit paid.
  • The strategy has limited profit potential and misses out on future gains if the stock price rises above the upper strike price.

Limited Upside Profit

If the stock price closes above the higher strike price on the expiration date, both options expire worthlessly.  The bull put spread option strategy earns the maximum profit which is equal to the credit taken when entering the position. The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Put

A drawback to the strategy is that it limits the profit earned if the stock rises well above the upper strike price of the sold put option. The investor would pocket the initial credit but miss out on any future gains.  If the stock is below the upper strike in the strategy, the investor will begin to lose money since the put option will likely be exercised. Someone in the market would want to sell their shares at this, more attractive, strike price. i

Limited Downside Risk

If the stock price drops below the lower strike price on the expiration date, then the bull put spread strategy incurs a loss.  The maximum loss is equal to the difference between the strike prices of the two puts minus the net credit received when putting on the trade. The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Short Put – Strike Price of Long Put Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying <= Strike Price of Long Put

Remember, the investor received a net credit for the strategy at the outset. This credit provides some cushion for the losses. Once the stock declines far enough to wipe out the credit received, the investor begins losing money on the trade.  If the stock price falls below the lower strike put option—the purchased put—both put options would have lost money, and maximum loss for the strategy is realized. The maximum loss is equal to the difference between the strike prices and the net credit received. i

Breakeven Point

The underlier price at which break-even is achieved for the bull put spread position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Put – Net Premium Received

Investors who are bullish on an underlying stock could use a bull put spread to generate income with limited downside. However, there is a risk of loss with this strategy.  The premium received by the seller is reduced depending on how far the stock price falls below the put option’s strike. The bull put spread is designed to allow the seller to keep the premium earned from selling the put option even if the stock’s price declines modestly.

Bull Put Spread Example 

An options trader believes that XYZ stock trading at $43 is going to rally soon and enters a bull put spread by buying a JUL 40 put for $100 and writing a JUL 45 put for $300. Thus, the trader receives a net credit of $200 when entering the spread position.  The stock price of XYZ begins to rise and closes at $46 on the expiration date. Both options expire worthlessly and the options trader keeps the entire credit of $200 as profit, which is also the maximum profit possible.

If the price of XYZ had declined to $38 instead, both options expire in-the-money with the JUL 40 call having an intrinsic value of $200 and the JUL 45 call having an intrinsic value of $700. This means that the spread is now worth $500 at expiration. Since the trader had received a credit of $200 when he entered the spread, his net loss comes to $300. This is also his maximum possible loss.

(Source: theoptionsguide)

Real-World Example of a Bull Put Spread

Let’s say an investor is bullish on Apple (AAPL) over the next month. Imagine the stock currently trades at $275 per share. To implement a bull put spread, the investor:

  1. Sells for $8.50 one put option with a strike of $280 expiring in one month
  2. Buys for $2 one put option with a strike of $270 expiring in one month

The investor earns a net credit of $6.50 for the two options, or $8.50 credit – $2 premium paid. Because one options contract equals 100 shares of the underlying asset, the total credit received is $650.

Scenario 1 Maximum Profit

Let’s say Apple rises and trades at $300 at expiry. The maximum profit is achieved and equals $650, or $8.50 – $2 = $6.50 x 100 shares = $650. Once the stock rises above the upper strike price, the strategy ceases to earn any additional profit.

Scenario 2 Maximum Loss

If Apple trades at $200 per share or below the low strike, the maximum loss is realized. However, the loss is capped at $350, or $280 put – $270 put – ($8.50 – $2) x 100 shares.  Ideally, the investor is looking for the stock to close above $280 per share on expiration, which would be the point at which maximum profit is achieved.

(Source: investopedia)

Up Next: What Does Sell To Open Mean?

 

Leave a comment

Your email address will not be published.