What is Bull Put Spread?

Bull put spread is an options strategy; it’s suitable for the traders that want to limit their loss. However, it comes with restricted profitability. In this article, we shall discuss detailed characteristics of the strategy, including opening the position.

An investor uses a bull put spread when they believe the underlying asset will rise moderately in price. It’s so-called because it generates a return when the price of an underlying asset increases. Further, it’s a put spread which means it’s an agreement to sell an asset in the future.

Explanation

Using two put options, the strategy creates a range with a high strike price and a low strike price. The investor receives a net credit from the difference between the two premiums. The premium received on the writing of put options is higher than the premium paid on buying the put options. Hence, it’s a credit spread, and net credit is the difference between the premium received and the premium paid on opening the position.

Bull put spreads are executed by an investor by purchasing a put option on security and selling a put option with a higher strike price on the same date. This strategy is used by investors who expect a moderate rise in the price of underlying assets. This strategy aims to make a profit on neutral and bullish moves of the underlying stock’s price.

Maximum profit

The maximum profit on this strategy is limited to the difference of premium received and paid on the position’s opening. The maximum profit is realized at expiration when both put options expire worthlessly, and the stock price is at or above the strike price of the short put higher strike.

Let’s understand maximum profitability with the help of an example. Consider following the position of the options.

Mr. Jimmy writes of or sells put options at a strike price of $100 and a premium of $3.20

Purchases put options at a strike price of  $95 and a premium of $1.30

Since the impact of the premium is the receipt. Hence, its credit spread amounting to $1.90 ($3.20-1.30) and maximum profitability is limited to the same. This level of maximum profitability can be achieved when the underlying asset price is at or above a higher strike price, which is $100 in the given position.

So, if the price of an underlying asset reaches $100 as per the bullish expectation of Mr. Jimmy, the strike price is equal to the market price. Hence, the buyer of the put options is not expected to exercise his right of selling. So, the premium received is profit for Mr. Jimmy. Similarly, Mr. Jimmy is not expected to exercise his right to sell as the market price is higher than the strike price. Hence, both put expire and premium receipt on the writing of the option in return for Mr. Jimmy.

READ:  Yield to Call – Definition, Example, and Analysis

Maximum loss

The maximum loss equals the difference between the strike prices of the position and the deduction of the net credit receipt plus commission. This can be expressed as follows. We have ignored the element of commission expense.

Maximum loss = (Higher strike price – lower strike price) – (premium received – premium paid)

So, we can apply the given position of Mr. Jimmy in the formula.

Maximum loss = (100-95) – (3.2-1.3)

Maximum loss = (5) – (1.9)

Maximum loss =3.1

That’s the maximum possible loss and can be realized when the underlying stock price is at a lower strike price (long put). This is because when the price is at a lower strike price, which is $95, the buyer of the put option shall exercise his right to sell the option at $100, which is the strike price. So, it will be a loss for Mr. Jimmy. However, the net premium received can be deducted to come at an actual loss figure.

So, losses are calculated as the difference between strike prices and net credit received.

Composition of the bull put spread position.

To form a bull put spread, short puts with a higher strike price are combined with long puts with a lower strike price. The underlying stock and expiration date are identical for both puts. Bull put spreads are established by receiving a net credit or net amount and profiting from rising stock prices or time erosion.

If the stock price falls below the long put’s strike price, it’s the loss limit. Further, profit is limited to the net premium received fewer commissions. It is a strategy that “collects option premium while limiting risk simultaneously.” By implementing the strategy, the trader gains from rising stock prices and time decay. The bull put spread is often used when prices are forecast to be neutral to increasing, and risk should be limited.

READ:  Leveraged Buyouts (LBO)

Profit and Loss

A bull put spread can be profitable if the price difference between the sold put and the purchased put is greater. Thus, the net credit at the beginning of the transaction represents the maximum profit, which only occurs if the stock closes above the higher strike price at the expiration date.

Bull put spreads achieve their goal when the underlying price moves or stays above the higher strike price. This results in the sold option being worthless. As a result, it expires worthless since no one is willing to exercise it and sell his shares at the strike price if the strike price is below the market price.

The strategy has the drawback of limiting the profits earned if the stock rises well above the strike price of the sold put options. If the stock rises above the strike price, the investor does not gain from the stock rise (it’s a limited gain).

Risk of early assignment for the strategy

Bull put spread contains risk of early assignment; it’s because options in the United States can be exercised on any date before expiration. So, the specific risk of the bull put strategy is affiliated with the holding short put stock at a higher strike price

The risk in the short put is that if the price of the underlying stock is below the higher strike price in the strategy, the buyer of the put option can exercise their right. Hence,  there is a risk of early assignment and damage for the whole strategy to generate the profit and limit the risk. On the other hand, such a situation does not arise in the long put.

Conclusion

Options strategies limit the risk of a loss on the trade. Bull put spread strategy is one of the effective strategies to limit the loss. However, it comes with the cost to limit the profit as well.

Bull put strategy is bullish. It means investors use this strategy when they expect the underlying asset’s price to increase. If the underlying asset price increases up to a higher strike price in the strategy, this is the point of maximum profit, and it’s equal to the net credit spread.

The net credit spread is the difference between payment of the premium and receipt of the premium in the opening put position. Further, the maximum profit of the strategy is equal to credit spread or net receipt of the premium.

READ:  Cash Conversion Cycle Vs Operating Cycle: What Is the Difference?

Similarly, the maximum loss on the strategy is limited to the difference of the strike price and net the credit spread when entering the position. So, profitability is achieved on the strategy when there is a bullish move in the price of an underlying asset. On the other hand, if there is a bearish (lower) movement of the price of an underlying security, it can lead to a loss on the strategy. Further, the maximum loss is restricted to the difference in strike prices.  

Frequently asked questions

Why is a bull put spread is the risky mode of strategy in the United States?

Because of the risk of early assignment, the buyer of the put options can exercise their right when the market price of the underlying security is below the higher stirk price. Further, in the United States, it’s possible to early exercise right on the options. Hence, the trader entering in the position should consider this risk.

What’s an advantage of implementing a bull put strategy?

The major advantage is limited losses. The trader does not presume unlimited risk due to speculation. However, it does limit the profitability of the trader.

Why do options strategies require the same date of expiry?

The options strategies require the same date of expiry because these strategies are designed to manage the risk under a specific period. So, both the sale and purchase of the options must cover simultaneous periods.

Name commonly used options strategies.

Following strategies are commonly used for the options.

  1. Bull put spread.
  2. Bear call spread.
  3. Long strangle
  4. Long straddle
  5. Long call butterfly
  6. Married put

Should traders use strategies to manage the risk on options?

The traders should use strategies as it helps to limit the potential of loss on speculation. Further, it’s important to note that speculation is regarded as one of the biggest problems with options trading.

So, different options strategies have been designed to limit the potential of a loss.

Scroll to Top