Bull Put Spread

What is a Bull Put Spread?

A bull put spread is an investment options strategy that requires investors to sell a put option at a specified strike price and buy a put at a lower strike price. In other words, it’s a strategy of buying and selling options to buy stocks based on the stock price speculation.

A bull put spread has the same maturity for both legs and investors earn on the difference between the strike price if the stock price rises higher than the strike price of the put that is sold. Generally, a bull put spread is constructed close to maturity because as maturity approaches, the value of the higher strike put will wear away.

To best implement a bull put spread strategy, investors should be sure that the stockprice will not drop to the lower strike put, and that it will remain at the same level or rise higher than the upper strike put to maturity.

The Bull Put Spread Explained

Investors typically use put options to profit from declines in a stock’s price, since a put option gives them the ability—though not the obligation—to sell a stock at 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.

Formulas for Bull Put Spread

To determine the maximum loss, and break-even point for a bull put spread, refer to the following formulas:

Max Gain = Net Premiums Received

Max Loss = Strike Price of Short Put - Strike Price of Long Put - Net Premiums Received

Break-even Point = Strike Price of Short Put - Net Premiums Received

Note that when the bull put spread position is entered, the investor starts with the maximum gain and faces potential losses as the strategy approaches maturity. Following, we will go through a comprehensive example outlining this.

Profits and Loss from Put Options

Investors typically buy put options when they are bearish on a stock, meaning 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, 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.

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.

The premium received by the seller would be 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.

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 expiration date. Both options expire worthless 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.

Note: While we have covered the use of this strategy with reference to stock options, the bull put spread is equally applicable using ETF options, index options as well as options on futures.

Summary

A bull put spread is a limited-risk, limited-reward strategy, consisting of a short put option and a long put option with a lower strike. This spread generally profits if the stock price holds steady or rises.

Motivation

Investors initiate this spread either as a way to earn income with limited risk, or to profit from a rise in the underlying stock’s price, or both.

Variations

A vertical put spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bear put spread for the bearish counterpart.

Max 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.

Max 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 worthless, and the investor pockets the credit received when putting on the position.

Profit/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.

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.

Breakeven

This strategy breaks even if, at expiration, the stock price is below the upper strike (short put strike) by the amount of the initial credit received. In that case, the long put would expire worthless, and the short put’s intrinsic value would equal the net credit.

Breakeven = Short put strike - Net credit received

Volatility

Slight, all other things being equal. Since the strategy involves being short one put and long another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree.

Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other.

Time Decay

The passage of time helps the position, though not quite as much as it does a plain short put position. Since the strategy involves being short one put and long another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree.

Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be a positive. This strategy generates net up-front premium income, which represents the most the investor can make on the strategy. If there are to be any claims against it, they must occur by expiration. As expiration nears, so does the date after which the investor is free of those obligations.

Assignment Risk

Yes. Early assignment, while possible at any time, generally occurs only when a put option goes deep into-the-money. Be warned, however, that using the long put to cover the short put assignment will require financing a long stock position for one business day.

And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

Expiration Risk

Yes. If held into expiration, this strategy entails added risk. The investor cannot know for sure whether or not they will be assigned on the short put until the Monday after expiration. The problem is most acute if the stock is trading just below, at or just above the short put strike.

Say, the short put ends up slightly in-the-money, and the investor sells the stock short in anticipation of being assigned. If assignment fails to occur, the investor won’t discover the unintended net short stock position until the following Monday and is subject to an adverse rise in the stock over the weekend.

There is risk in guessing wrong in the other direction, too. This time, assume the investor bets against being assigned. Come Monday, if assignment occurs after all, the investor has a net long position in a stock that may have lost value over the weekend.

Two ways to prepare: close the spread out early, or be prepared for either outcome on Monday. Either way, it’s important to monitor the stock, especially over the last day of trading.

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