Bull Put Spread Step-by-Step Guide How to Execute Options Trading Strategy with Examples

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Marketopedia / Learn about Option Strategies / Bull Put Spread Step-by-Step Guide How to Execute Options Trading Strategy with Examples

Why Bull Put Spread?

The Bull Put Spread is similar to the Bull Call Spread, but with different strategic execution and strike selection. It is a two-legged option strategy that is utilized when one has a moderately bullish opinion of the market. It employs Put instead of Call options to create a spread, resulting in a payoff structure similar to that of the Bull Call Spread.

At this point, you may wonder why to choose one strategy over another when the payoffs from both Bull call spread and Bull Put spread are similar.

The attractiveness of the premiums is what determines which strategy you take. While executing a Bull Call Spread requires a debit, executing a Bull Put Spread means you receive a credit. It all comes down to the current state of the market.

  1. The markets have seen a significant drop, (consequently causing an increase in PUT premiums).
  2. The volatility is on the higher side
  3. There is plenty of time to expiry

If you take a moderately optimistic view of the future, then a Bull Put Spread is an appealing option as it provides a net credit. Personally I’m more attracted to strategies that bring in income rather than strategies that require an outlay.

– Strategy Notes

The bull put spread is a two-legged strategy that typically uses ITM and OTM Put options; however, other strike prices can also be used.

To implement the bull put spread –

  1. Buy 1 OTM Put option (leg 1)
  2. Sell 1 ITM Put option (leg 2)

When you do this ensure –

  1. All strikes belong to the same underlying
  2. Belong to the same expiry series
  3. Each leg involves the same number of options

For example –

Date – 7th December 2015

Outlook – Moderately bullish (expect the market to go higher)

Nifty Spot – 7805

Bull Put Spread, trade set up –

  1. Buy 7700 PE by paying Rs.72/- as premium; do note this is an OTM option. Since money is going out of my account this is a debit transaction
  2. Sell 7900 PE and receive Rs.163/- as premium, do note this is an ITM option. Since I receive money, this is a credit transaction
  3. The net cash flow is the difference between the debit and credit i.e 163 – 72 = +91, since this is a positive cashflow, there is a net credit to my account.

Generally speaking, in a bull put spread there is always a ‘net credit’, hence the bull put spread is also called referred to as a ‘Credit spread’.

Once we start the trade, the market may move in either direction and expire at any point. So, let’s go through a few scenarios to understand what could happen to the bull put spread if it happens to end at a specific level.

Scenario 1 – Market expires at 7600 (below the lower strike price i.e OTM option)

The value of the Put options at expiry depends upon its intrinsic value. If you recall from the previous module, the intrinsic value of a put option upon expiry is –

Max [Strike-Spot, o]

In case of 7700 PE, the intrinsic value would be –

Max [7700 – 7600 – 0]

= Max [100, 0]

= 100

Since we are long on the 7700 PE by paying a premium of Rs.72, we would make

= Intrinsic Value – Premium Paid

= 100 – 72

= 28

Similarly, the 7900 PE option has an inherent value of 300, but we have already sold this option at 163 rupees.

Payoff from 7900 PE this would be –

163 – 300

= – 137

Overall strategy payoff would be –

+ 28 – 137

= – 109

Scenario 2 – Market expires at 7700 (at the lower strike price i.e the OTM option)

The 7700 PE will have no inherent worth, so we will forfeit the premium we paid, Rs.72 in this instance.

The 7900 PE’s intrinsic value will be Rs.200.

Net Payoff from the strategy would be –

Premium received from selling 7900PE – Intrinsic value of  7900 PE – Premium lost on 7700 PE

= 163 – 200 – 72

= – 109

Scenario 3 – Market expires at 7900 (at the higher strike price, i.e ITM option)

The intrinsic value of both 7700 PE and 7900 PE would be 0, hence both the potions would expire worthless.

Net Payoff from the strategy would be –

Premium received for 7900 PE – Premium Paid for 7700 PE

= 163 – 72

= + 91

Scenario 4 – Market expires at 8000 (above the higher strike price, i.e the ITM option)

Both the 7700 PE and 7900 PE could expire worthless, resulting in a total payoff for the strategy.

Premium received for 7900 PE – Premium Paid for 7700 PE

= 163 – 72

= + 91

To summarize –

From this analysis, 3 things should be clear to you –

  1. This strategy is beneficial when the market rises.
  2. The market may have taken a dip, but the maximum amount that could be lost is limited to only Rs.109, which is the difference between the “spread” and “net credit” of the strategy.
  3. The strategy’s maximum profit is limited to 91, which is also the net credit.

We can clearly see that the maximum loss is limited to Rs.109 and the maximum profit is capped at Rs.91. This allows us to determine the boundaries for the Bull Put Spread, where we will know their respective max levels of loss and profit.

Bull PUT Spread Max loss = Spread – Net Credit

Net Credit = Premium Received for higher strike – Premium Paid for lower strike

Bull Put Spread Max Profit = Net Credit

 

There are three important points to note –

  1. This strategy incurs a loss if Nifty settles below 7700, however, the maximum amount of money lost is limited to Rs.109.
  2. The breakeven point is attained when the market expires at 7809, meaning that the generalization of the Bull Put spread is Higher Strike – Net Credit.
  3. This strategy yields profits when the market value surpasses 7809, with a maximum potential gain of Rs.91 that is the gap between the Premium Received from an In-the-Money PE and the Premium Paid for an Out-of-the-Money PE.
  • Premium Paid for 7700 PE = 72
  • Premium Received for 7900 PE = 163
  • Net Credit = 163 – 72 = 91

– Other Strike combinations

The spread is the gap between the two strike prices, and the Bull Put Spread is composed of one Out-of-the-Money (OTM) Put and one In-the-Money (ITM) Put. Any combination of OTM and ITM strikes may be selected, and the wider the separation between them, the higher the potential payouts.

Let us take some examples considering spot is at 7612 –

The point is that you can build a spread with OTM and ITM options. The risk reward ratio alters depending on which strikes you pick, which then decides the spread. If you are confident in a moderately bullish view, consider constructing a bigger spread; if not, stick to something smaller.

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