What Is A Bull Put Spread?5 min read
A bull put spread involves short selling a put option as well as purchasing another put option with a lower strike price (on the same underlying asset) with the same expiration date.
Why Is It Used?
The motive of a bull put spread is to profit from a neutral to bullish price action in the stock price.
Mechanism
A bull put spread consists of two put options with the same expiration date and underlying stock. The two put options consist of a long put and a short put. The long put has the smaller strike price and the short put has the higher strike price.
The profit rises as the stock price rises or with time erosion or both. The potential profit is limited to the net premium received less brokerage and other charges. Potential loss is limited if the stock price falls below the strike price of the long put.
Maximum Profit
Potential profit is limited to the net premium received minus brokerage and other charges. This profit is realized if the stock price at expiration is at or above the strike price of the short put.
Let us assume that the underlying is a stock called X. The bull put spread strategy buys a put on X with strike Rs. 50 at a price of Rs. 1 and sells a put on X with strike Rs. 55 at a price of Rs. 3. This means that the net cost of the bull put spread is Rs. 2 (3-1=2).
So, the maximum profit is = Rs. 2 per share minus brokerage and other expenses
The maximum profit is realized if the stock price is at or above the strike price of short put option at expiration.
Maximum Loss:
Maximum loss is equal to the difference between the strike prices minus the net credit received including brokerages and other charges.
In the above example, the difference between the strike prices is Rs. 5 (Rs. 55 – Rs. 50) and net credit is Rs. 2 (Rs. 3 – Rs. 1). The maximum loss is Rs. 5 – Rs. 2 = Rs. 3 Per share plus brokerage and other charges. This happens when the stock price at expiration is below the strike price of the long put.
Scope Of The Strategy
Bull put spread profits from both time decay and rising stock prices. The strategy essentially collects option premium and limits risk at the same time. This should be the go to strategy when the prediction is neutral to rising prices and at the same time there is a desire to limit the risk.
What Happens When Stock Price Changes?
The strategy has a net positive delta because the bull put spread profits when the stock price rises and loses when the stock price falls. Since a bull put spread consists of one long put and one short put, the net delta changes very little as the stock price changes and the time to expiration is also unchanged. This essentially means that the strategy has a near zero gamma.
What Happens When Volatility Changes?
Volatility is a measure of how much the stock price deviates from it’s mean. Option prices rise with volatility if the other relevant factors remain constant. Since a bull call spread consists of a long put and a short put, the price of a bull call spread changes very little when volatility changes. The strategy approximately has a near zero vega.
What Happens As Time Passes By?
As a bull put spread consists of one short put and one long put, the sensitivity to time decay depends on the relationship of the stock price to the strike prices of the bull put spread.
- If the stock price is close to or above the strike price of the short put, then the price of the bull put spread decreases with passing time.
- If the stock price is close to or below the strike price of the long put, then the price of the bull put spread increases with passing time.
- If the stock price is half-way between the strike prices, then time erosion has little effect on the price of a bull put spread, because both the short put and the long put erode at approximately the same rate.
Positions At Expiration
The stock price at expiration can be as follows:
- At or higher than the higher strike price
- Below the higher strike price but not below the lower strike price
- Below the lower strike price
If the stock price is at or above the higher strike price, then both puts in a bull put spread expire worthless and no stock position is created.
If the stock price is below the higher strike price but not below the lower strike price, then the short put is assigned and a long stock position is created.
If the stock price is below the lower strike price, then the short put is assigned and the long put is exercised. The result is that stock is purchased at the higher strike price and sold at the lower strike price and the result is no stock position.
Check out the blog on Bull Call Spread too!
Disclaimer –
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