Bull Put Spread Explained



The bull put spread strategy should be deployed when you think the underlying asset will go up moderately in the short term.

Bull put spreads are implemented by selling a higher strike in-the-money put option and buying a lower strike out-of-the-money put option of the same underlying asset with the same expiration date.

Here’s how it’s constructed:

Buy 1 Out of The Money (OTM) Put – Sell 1 In The Money (ITM) Put

Maximum Profit Potential

If the underlying asset closes above the higher strike price upon expiration, both options expire worthless and you’ll earn the maximum profit available, which is equal to the credit taken when entering the position.

You can calculate the maximum profit potential using the formula below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Put

Maximum Potential Loss

If the price of the underlying asset drops below the lower strike price upon expiration then you’ll incur the maximum possible loss, which is equal to the difference between the strike prices of the two puts minus the net credit received when placing the trade.

You can calculate the maximum possible loss by using the formula below:

  • Max Loss = Strike Price of Short Put – Strike Price of Long Put Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven

The underling price at which breakeven occurs can be calculated using the following formula:

  • Breakeven Point = Strike Price of Short Put – Net Premium Received

Bull Put Spread Trading Example

Let’s say you think that IBM stock currently trading at $43 is undervalued and heading for a rally, so you enter a bull put spread by buying a MAY 40 put for $100 and writing a MAY 45 put for $300. You’ll receive a net credit of $200 when entering the spread position.

Sure enough the stock price of IBM begins to rise and closes at $46 upon expiry. Both options will subsequently expire worthless and you’ll get to keep the entire credit of $200 you received for entering the spread as profit.

On the other hand if the price of IBM had declined to $38, both options would expire in-the-money with the MAY 40 call having an intrinsic value of $200 and the MAY 45 call having an intrinsic value of $700. This means that the spread is now worth $500 at expiry. Since you received a credit of $200 when you entered the spread, your net loss comes to $300.

Commission

For simplicities sake the above example doesn’t include any trading commissions. In the real world this and any other option trade for that matter will incur trading commissions from your broker. These commissions are usually quite small, typically around $10 or $20.

As you get more experienced and start stringing together more complex multi-legged trades these commissions can start to eat into your profit. Fortunately there are brokers available that offer reduced rates for active traders. A good example of this type of broker is OptionsHouse who offer frequent traders commissions starting at $0.15 per contract (+$8.95 per trade).

Conclusion

The bull put spread is a simple strategy to understand and implement, it also has the added advantage of a limited downside. For this reason it’s an ideal first strategy for rookies.

Just remember to always test it out in a virtual environment before you commit any real capital. When you can confidently use it to earn regular profits you can add it to your trading arsenal and you’ll be one step closer to being a successful options trader.




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