Introduction To Bull Put Spreads
A bull put spread is a credit spread that involves selling a put option that is in the money and then buying an out of the money put option with a lower exercise(strike)price.The strategy entails that for every put option contract sold, a put option contract is bought. By doing so, a trader limits upside profit and risks to the downside.
Net Credit
A bull put spread is also a credit spread as a net premium is collected from its execution. What the trader must take note of is that the credit received compensates the trader for the risk taken to place the trade.
Lower commission costs
In general, under favorable conditions as prices of the underlying securities move up, credit spreads such as the bull put spread have lower commission costs than debit spreads such as the bull call spread as commissions can be avoided completely by allowing the options to expire worthless.
Margin requirement
Margin is required to execute a bull put spread. The amount of margin is subject to broker’s discretion.
Considerations to make when choosing a bull put spread(credit spreads)
- Options lose time value as they approach expiration. This causes the premium to decline towards expiration date with all things being equal.For a trader to earn the maximum profit from a bull put spread, the options expiring worthless. Due to that, traders select options that have a rapid rate of time value decline. A general rule is to use options with 45 days or less to expiration. In the absence of any major price moves to the downside, the options will eventually expire worthless, thereby earning the trader a maximum profit. In this case, time decay is especially useful to the bull put position.
- Select options which will result is the greatest net credit. The greater the net credit, the greater the maximum profit.
- Select options that have a small difference in strike prices. A small difference in strike prices will minimise the risk taken.
- Insist on a favorable risk and reward ratio. Option traders can divide the maximum profit over the maximum potential loss. A trade with a high risk and reward ratio is more favorable than another with a low risk and reward ratio.
- For the trade to be profitable, the breakeven point should be within the trading range of the underlying security.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Moderately Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited losses
Step 7 : Loss calculation
Step 8 : Limited potential profit
Step 9 : Maximum profit calculation for bull put spread
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a bull put spread
Step 12 : Exit Trade : Exiting a bull put spread
Step 13 : Record Trade In Diary
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Step 1 : Perform economic, fundamental and technical analysis
Perform a general analysis of the economy to gauge market direction. Also, conduct fundamental analysis to find out the intrinsic value of the underlying security. Last but not least, perform some technical analysis to find the best entry and exit point. Suggested chart patterns option traders should look out for before executing a bull put spread are:
At levels of resistance when there is a probability of reversal, the options trader may want to exit the trade completely or offset the written option, holding onto the long option position for a possible profit.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Moderately Bullish
When a trader makes a bull put spread, he is moderately bullish about the underlying security. The trader that executes a bull put spread expects the price of the underlying security to trade and close above the exercise(strike)price of the short put position. In the favorable event, a maximum profit is earned from the net credit collected.
Step 3 :Study the option chain
After determining the outlook, the options trader should look at the options chain. Select the options to use for the creation of the bull put spread.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
Breakeven price point = Exercise price of the written(short) put – net credit received
The exercise price of a put that is written is the price at which a put option writer has to buy shares if assignment takes place. Seeing it in that perspective, the net premiums(credit) received when the bull put spread was executed acts to reduce the cost of the purchase of shares if assignment takes place.
Step 5: Understand Your Profit Zones
After calculating the breakeven point, the trader should understand that the profit zone is to the right of the breakeven point.
Step 6 : Limited losses
When the price of the underlying security falls below the exercise(strike)price of the put option which was bought, the trader incurs a maximum possible loss which is limited. Hence, there is limited downside risk to this strategy.
Step 7 : Loss calculation
The maximum loss = Difference between the 2 exercise prices – Net credit + commissions paid to the broker
Step 8 : Limited potential profit
A bull put spread is created by selling 1 in the money put option contract and buying and out of the money put option contract. Since the in the money put option contract is more expensive than the out of the money put option contract, a credit is received by the trader. If the price of the underlying security is trading above the exercise(strike)price of the put option which was sold, both options will expire worthless.
Step 9 : Maximum profit calculation for bull put spread
The maximum profit occurs when the price of the underlying security is greater than the exercise(strike)price of the put option that was shorted
Maximum profit = Net credit – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
Once the maximum loss and reward can be calculated, the trader should calculate the risk reward ratio. Doing so will help the trader determine the attractiveness of the trade.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing a bull put spread
- Short a higher strike put option
- Buy a lower strike put option
- Ratio of the short put to long put is 1 : 1.
Step 12 : Exit Trade : Exiting a bull put spread
- If the price of the underlying security trades above the short strike price, the options will expire worthless and the trader gets to keep the net credit. This is the best case scenario and the scenario.
- If the price of the underlying security trades at a price above the breakeven point but does not go above the short strike price, the short put may be assigned. When the holder of that option exercises his right, the options trader will have to buy the underlying security from the option holder and sell it back to the open market. A small loss may result. However, the trader could hold on to the long put and sell it for a profit.
- If the price of the underlying security trades between the breakeven point and the long strike price, the trader may be obligated to purchase the underlying security from the option buyer. Next, he can sell the underlying security in the open market. In this scenario, a loss will result.
- If the price of the underlying security falls below the long strike price, the option trader may have to buy the underlying security at the higher strike price, exercise the right to sell it at the lower strike price, thereby incurring a maximum loss. This is the least favorable scenario.
Step 13 : Record Trade In Diary
Last but not least, record the trade in the diary for analysis and comparison against other trades. Doing so over time will make a trader a sharper one. Make a concerted effort not to repeat the same mistakes and the trader should improve on his or her trading algorithm.
Example of a bull put spread
Wells Fargo & Co is currently trading at $55.85 at the time of this writing.
This is an options chain of Wells Fargo.
A trader may be moderately bullish on this company and he decides to place a bull put spread. He sells a December 57.5 put option at $215 and buys a December 52.5 put option at $54. The credit received is $215 – $54 = $161
Eventually, Wells Fargo trades at $58 on the expiration day of the options. When that happens, the trader gets to keep $161 because the options expire worthless.
If Wells Fargo trades below $52.50, the trader’s maximum loss is the difference between the exerciseprices of the 2 options less the credit received. The trader loses: $500 – $161 = $339 (Not excluding commissions) Now, when a put option owner has the right to buy shares at a certain exercise price and a put option writer has the obligation to buy those shares at a certain strike price. From that perspective, when the trading price of Wells Fargo is below $52.50, the trader has to incur a loss that is equal to the difference between the two exercise(strike) prices less the premium collected.
Bull put spread vs bull call spread
A bull put spread results in a credit to your trading account while a bull call spread results in a debit to your account. A bull put spread is constructed with put options with the same expiry date while a bull call spread is constructed with call options with the same expiry.
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