What is a bull put spread strategy?

Posted on: April 26th, 2022
By: Tadeo Martinez

When a trader expects a modest price increase for the underlying asset, they might use a bull put spread. A range is created with two put options, one with a high strike price and one with a low strike price. The difference in premiums between the two options gives the investor a net credit.

How to understand the bull put spread

Put options are commonly used by investors to make money from a stock’s price falling. Because a put option gives investors the ability—but not an obligation—to sell a stock at or before the contract expiration date, they’re typically utilized to profit from drops in price. The strike price of each put option is the price at which the option converts to the underlying security. Investors pay a premium for each put option that they buy.

How profits and loss works with put options

When investors are bearish on a stock, they buy put options to bet that the stock will drop below the option’s strike price. The bull put spread, on the other hand, was created to profit from a stock’s appreciation.

If the stock performs better than the strike by expiration, the put option expires worthless since no one will sell shares at a price lower than market price. As a result, the buyer of the put loses the premium that they paid.

On the other hand, an investor who sells a put option expects the stock to rise above the strike and have the put option expire worthless. The premium received by an option writer—the person who sold you the option—is intended to be kept.

However, if the stock falls beneath the strike price, the put seller is on the hook. The option owner has a gain and will sell shares at a premium. In other words, the put option is exercised in return for cash.

A trailing stop loss is a form of limit order that “goes bad” if the stock’s price dips below the put option’s strike. The bull put spread protects the seller from losing money by allowing him to keep the premium earned from selling the put option even if stock prices fall.

Structure of the bull put spread

A bull put spread is made up of two put options. An investor purchases one put option and pays a premium, while simultaneously selling a second put option with a higher strike price than the first for a premium. Both options will have the same expiration date.

If the underlying stock rises and the puts lose value, both options would expire worthless if the underlying price reaches or exceeds the highest strike. As a result, the maximum profit would be equal to the premium received for creating the spread.

A bull put spread can be used by investors who are bullish on stock to produce income with limited risk. There is, however, the danger of losing money with this technique.

The strategy of Bull Put Profit and Loss

The maximum profit for a bull put spread is the difference between the money received from the sold put and the cash paid for the purchased put, regardless of whether or not the stock’s price reaches or exceeds the higher strike price at expiration.

When the underlying’s price rises or remains above the higher strike price, the bull put spread goal is achieved. The sold option expires worthless as a result of this. Because no one would want to sell their shares at the strike price if it was lower than the market price, no one would be willing to exercise it and sell their shares at that price.

The disadvantage of this approach is that if the stock price rises significantly above the upper strike price of the sold put option, the investor will only earn a profit if it falls back below. The investor would get his or her initial credit but miss out on any future profits.

If the stock is below the strategy’s upper strike, the investor will start to lose money as soon as the put option is exercised. Someone in the market would want to sell their shares at this more appealing strike price.

The investor, on the other hand, obtained a net credit for the plan at first. This cushion helps to alleviate some of the pain. Once the stock falls far enough that the credit received is erased, the investor starts losing money on his or her position.

If the stock price drops below the purchased put—the put option that was bought—both put options would have incurred a loss, and the strategy’s maximum potential loss would be realized. The maximum loss is equal to the difference between the strike prices and the net credit received.

Example of bull put spread

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

  1. Sells one put option for $10 with at strike price $290 that expires in one month.
  2. Buys one put option with for $3 at strike price $270 that expires in one month.

In this case the investors receives a premium of $7 for the two options contracts ($10 credit minus the $3 paid).

One options contracts is the same as owning 100 shares of the stock so you multiply the premium times 100, making the actual credit received $700.

Maximum Profit: Scenario 01

Let’s pretend the stock rises to $300 at the date of expiration. The maximum profit received is the original credit received of $700 in this case. When the stock price goes above the upper strike price, this strategy will no longer earn any money.

Maximum Loss: Scenario 02

If the stock trades at $250 per share or goes below the lowest strike price, this is when the maximum loss happens. But since it’s a spread, the loss has a limit at $1,600, $290 put – $270 put – ($7 – $3) times 100 because with options you own 100 shares of the stock.

On expiration, the buyer wants the stock to reach at least $290 per share, which will be the moment at which maximum gain is made.

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