Bull Put Spread

Reasons for Using the Bull Put Spread

You would generally use this spread if you expect that a security is going to rise in price, but not by much. Also if you want to profit from such a move and want some protection if the security falls in price unexpectedly. It's essentially an extension of the short put, with added protection against a fall in price, because it limits losses if that should happen.

As you can also make a profit if the price of the security doesn’t move at all, it's a good strategy when you aren't fully confident in your bullish outlook.

How to Create a Bull Put Spread

Creating the spread is relatively straightforward, and it requires two simultaneous transactions. You need to write puts based on the underlying security that you are expecting to rise in price (using the sell to open order), and buy the same amount of puts based on that security (using the buy to open order).

You should make sure that the puts that you write have a higher strike price than those that you buy, because these will be more expensive and you will therefore create a credit spread and receive an upfront credit. The options that you buy and the ones that you write should have the same expiration date, preferably a relatively short term one.

As a general rule, you should write at the money puts and buy out of the money ones. You can also write in the money puts if you want to increase your potential profits, but this means you'll need the price of the underlying security to go up by more. Basically, the bigger the difference between the strike prices of the contracts you write and the ones you buy, the more you stand to gain, but the more you stand to lose.

Potential for Profit & Loss

The ideal scenario for this strategy is that the contracts that you write expire out of the money, meaning that you have no further liability and the net credit that you receive at the outset is all profit. If you write at the money contracts, then you will make the maximum profit even if the underlying security doesn't go up in price, providing it doesn't go down.

If you write in the money contracts, then you will need the price of the underlying security to increase to at least the strike price of those contracts. While you don't make any further returns if the price of the underlying security goes even higher, there's no negative impact either.

The strategy will be a losing proposition if the underlying security falls in price. If the puts that you write expire in the money, then they will be exercised and you will have to buy the relevant underlying security at the agreed strike. The maximum loss would be made if the underlying security fell to the strike of the puts that you buy.

If it falls any lower than that, then you'll be able to exercise the puts you own and sell the underlying security at the agreed strike of those options. Therefore, the maximum loss (per option written) is the difference between the strike of the options that you write and the ones that you buy.

Benefits

There are two main benefits of this spread. First, assuming you write at the money puts when applying the strategy, you will still make a profit even if the underlying security fails to go up in price. Although the puts you own will expire worthless, so will the ones that have written and you therefore get to keep the entire upfront credit.

The second advantage is that you limit your potential losses by buying the out of the money puts. Although there's a cost associated with this, and it reduces the size of the credit from writing the more expensive puts, this extra level of protection can obviously be very appealing.

This spread is a little more complex than some of the basic trading strategies, but there are only two transactions involved so the commission costs aren't very high. It's also relatively easy to calculate the maximum profit potential and the maximum loss potential at the time of applying the strategy.

Drawbacks

One drawback of this spread is that your profits are limited if the underlying security increases dramatically in price, unlike the long call where you can continue to make profits however high the price goes. However, as the bull put spread is specifically designed to be used when expecting only a small price increase; this isn't necessarily that relevant.

Another drawback is that the strategy requires margin, meaning you will have to tie up capital in your broker account. Finally, because it involves writing puts, there's always the possibility that they will be assigned and you could be forced to buy the underlying security. This will mean incurring additional commissions if you then want to sell the security.

Example

Below is a basic example of how the spread works in practice, and what would happen in some hypothetical scenarios. This is just a rough guide to the strategy and does not include precise prices, and commission fees haven't been taken into account.

Initial Trade

• Company X stock is trading at $50, and you expect it to increase in price by a small amount.
• At the money puts on Company X stock (strike price $50) are trading at $2 and out of the money put options on Company X stock (strike price $48) are trading at $1.
• You write 1 put contract with a strike price of $50 (each contract contains 100 shares) for a credit of $200. This is Leg A.
• You buy 1 put contract with a strike price of $48 (each contract contains 100 options) at a cost of $100. This is Leg B.
• You have created a bull put spread for a net credit of $100.

If Company X stock increases to $52 by expiration

The options you have written in Leg A are out of the money and expire worthless. The ones you have bought in Leg B are also out of the money, and expire worthless. You have no further liabilities and no further returns, so the net credit of $100 is your profit.

If Company X stock remains at $50 by expiration

As above, the options in both Leg A and Leg B expire worthless meaning you have no further liabilities and no further returns. The net credit of $100 is your profit.

If Company X stock falls to $48 by expiration

The options written in Leg A will be in the money, giving you a liability of around $2 per option written. Your total liability is $200. The ones bought in Leg B will be at the money, and will expire worthless. You have a total liability of $200, which is offset by the initial credit of $100 for a total loss of $100.

If Company X stock fell even further than $48, your loss would still be limited to around $100. Your liability on the options written in Leg A would increase, but the ones bought in Leg B would increase in value proportionately. If Company X stock went any higher than $52, your profits would still be limited to $100, because the best case scenario is that the options in both legs expire worthless and you make the initial net credit as your profit.

You should remember that you can close your position at any time, to either lock in profits, or cut your losses.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security > or = Strike Price of Leg A”
• Maximum profit, per option owned, is “Price of Option in Leg A – Price of Option in Leg B”
• Maximum loss is limited.
• Maximum loss is made when “Price of Underlying Security < or = Strike Price of Leg B”
• Maximum loss per option owned is “(Strike Price of Leg A – Strike Price of Leg B) - (Price of Option in Leg A – Price of Option in Leg B)”
• Break-even point is when “Price of Underlying Security = Strike Price of Leg A - (Price of Options in Leg A – Price of Options in Leg B)”

Summary

The bull put spread is a good choice of strategy for traders that are looking to make a relatively quick profit from a small increase in the price of a security. Although profits are limited, so are losses, and as such it's an appropriate strategy if you have concerns that the security could possibly fall in price instead. Because of the high trading level required, we would advise beginners to consider alternative strategies.