Bull Spreads Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker!
    Perfect Choice For Beginners and Middle-Level Traders!
    Free Demo Account! Free Education!

  • Binomo
    Binomo

    Honest broker!

Bull Put Spread

The bull put spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term. The bull put spread options strategy is also known as the bull put credit spread as a credit is received upon entering the trade.

Bull Put Spread Construction
Buy 1 OTM Put
Sell 1 ITM Put

Bull put spreads can be implemented by selling a higher striking in-the-money put option and buying a lower striking out-of-the-money put option on the same underlying stock with the same expiration date.

Limited Upside Profit

If the stock price closes above the higher strike price on expiration date, both options expire worthless and the bull put spread option strategy earns the maximum profit which is equal to the credit taken in when entering the position.

The formula for calculating maximum profit is given below:

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

Limited Downside Risk

If the stock price drops below the lower strike price on expiration date, then the bull put spread strategy incurs a maximum loss equal to the difference between the strike prices of the two puts minus the net credit received when putting on the trade.

The formula for calculating maximum loss is given 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

Breakeven Point(s)

The underlier price at which break-even is achieved for the bull put spread position can be calculated using the following formula.

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

Bull Put Spread Example

An options trader believes that XYZ stock trading at $43 is going to rally soon and enters a bull put spread by buying a JUL 40 put for $100 and writing a JUL 45 put for $300. Thus, the trader receives a net credit of $200 when entering the spread position.

The stock price of XYZ begins to rise and closes at $46 on expiration date. Both options expire worthless and the options trader keeps the entire credit of $200 as profit, which is also the maximum profit possible.

If the price of XYZ had declined to $38 instead, both options expire in-the-money with the JUL 40 call having an intrinsic value of $200 and the JUL 45 call having an intrinsic value of $700. This means that the spread is now worth $500 at expiration. Since the trader had received a credit of $200 when he entered the spread, his net loss comes to $300. This is also his maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the bull put spread is equally applicable using ETF options, index options as well as options on futures.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker!
    Perfect Choice For Beginners and Middle-Level Traders!
    Free Demo Account! Free Education!

  • Binomo
    Binomo

    Honest broker!

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the bull put spread in that they are also bullish strategies that have limited profit potential and limited risk.

Bull Spread

What Is a Bull Spread?

A bull spread is an optimistic options strategy designed to profit from a moderate rise in the price of a security or asset. A variety of vertical spread, it involves the simultaneous purchase and sale of either call options or put options with different strike prices but with the same underlying asset and expiration date. Whether a put or a call, the option with the lower strike price is bought and the one with the higher strike price is sold.

A bull call spread is also called a debit call spread because the trade generates a net debt to the account when it is opened. The option purchased costs more than the option sold.

The Basics of a Bull Spread

If the strategy uses call options, it is called a bull call spread. If it uses put options, it is called a bull put spread. The practical difference between the two lies in the timing of the cash flows. For the bull call spread, you pay upfront and seek profit later when it expires. For the bull put spread, you collect money up front and seek to hold on to as much of it as possible when it expires.

Both strategies involve collecting a premium on the sale of the options, so the initial cash investment is less than it would be by purchasing options alone.

Key Takeaways

  • A bull spread is an optimistic options strategy used when the investor expects a moderate rise in the price of the underlying asset.
  • Bull spreads come in two types: bull call spreads, which use call options, and bull put spreads, which use put options.
  • Bull spreads involve simultaneously buying and selling options with the same expiration date on the same asset, but at different strike prices.
  • Bull spreads achieve maximum profit if the underlying asset closes at or above the higher strike price.

How the Bull Call Spread Works

Since a bull call spread involves writing a call option for a higher strike price than that of the current market in long calls, the trade typically requires an initial cash outlay. The investor simultaneously sells a call option, aka a short call, with the same expiration date; in so doing, he gets a premium, which offsets the cost of the first, long call he wrote to some extent.

The maximum profit in this strategy is the difference between the strike prices of the long and short options less the net cost of the options—in other words, the debt. The maximum loss is only limited to the net premium (debit) paid for the options.

A bull call spread’s profit increases as the underlying security’s price increases up to the strike price of the short call option. Thereafter, the profit remains stagnant if the underlying security’s price increases beyond the short call’s strike price. Conversely, the position would have losses as the underlying security’s price falls, but the losses remain stagnant if the underlying security’s price falls below the long call option’s strike price.

How the Bull Put Spread Works

A bull put spread is also called a credit put spread because the trade generates a net credit to the account when it is opened. The option purchased costs less than the option sold.

Since a bull put spread involves writing a put option that has a higher strike price than that of the long call options, the trade typically generates a credit at the start. The investor pays a premium for buying the put option but also gets paid a premium for selling a put option at a higher strike price than that of the one he purchased.

The maximum profit using this strategy is equal to the difference between the amount received from the sold put and the amount paid for the purchased put – the credit between the two, in effect. The maximum loss a trader can incur when using this strategy is equal to the difference between the strike prices minus the net credit received.

Benefits and Disadvantages of Bull Spreads

Bull spreads are not suited for every market condition. They work best in markets where the underlying asset is rising moderately and not making large price jumps.

As mentioned above, the bull call limits its maximum loss to the net premium (debit) paid for the options. The bull call also caps profits up to the strike price of the option.

The bull put, on the other hand, limits profits to the difference between what the trader paid for the two puts—one sold and one bought. Losses are capped at the difference between strike prices less the total credit received at the creation of the put spread.

By simultaneously selling and buying options of the same asset and expiration but with different strike prices the trader can reduce the cost of writing the option.

What Is A Bull Put Spread?

A bull put spread is a variation of the popular put writing strategy, in which an options investor writes a put on a stock to collect premium income and perhaps buy the stock at a bargain price. A major risk of put writing is that the investor is obligated to buy the stock at the put strike price, even if the stock falls well below the strike price, resulting in the investor facing an instant and sizable loss. A bull put spread mitigates this inherent risk of put writing through the concurrent purchase of a put at a lower price, which reduces the net premium received but also lowers the risk of the short put position.

Bull Put Spread Definition

A bull put spread involves writing or short selling a put option, and simultaneously purchasing another put option (on the same underlying asset) with the same expiration date but a lower strike price. A bull put spread is one of the four basic types of vertical spreads – the other three being the bull call spread, the bear call spread and the bear put spread. The premium received for the short put leg of a bull put spread is always more than the amount paid for the long put, which means that initiating this strategy involves receiving an upfront payment or credit. A bull put spread is, therefore, also known as a credit (put) spread or a short put spread.

Profiting from a Bull Put Spread

A bull put spread should be considered in the following situations:

  • To earn premium income: This strategy is ideal when the trader or investor wishes to earn premium income, but with a lower degree of risk than through writing puts only.
  • To buy a stock at a lower price: A bull put spread is a good way to buy a desired stock at an effective price that is lower than its current market price.
  • To capitalize on sideways to marginally higher markets: Put writing and bull put spreads are optimal strategies for markets and stocks that are trading sideways to marginally higher. Other bullish strategies, such as buying calls or initiating bull call spreads, would not work as well in such markets.
  • To generate income in choppy markets: Put writing is risky business when markets slide because of the greater risk of being assigned stocks at needlessly high prices. A bull put spread may enable puts to be written even in such markets by capping downside risk.

A hypothetical stock, Bulldozers Inc., is trading at $100. An option trader expects it to trade up to $103 in one month, and while she would like to write puts on the stock, she is concerned about its potential downside risk. The trader therefore writes three contracts of the $100 puts – trading at $3 – expiring in one month, and simultaneously buys three contracts of the $97 puts – trading at $1 – also expiring in one month.

Since each option contract represents 100 shares, the option trader’s net premium income is:

($3 x 100 x 3) – ($1 x 100 x 3) = $600

(Commissions are not included in the calculations below for the sake of simplicity.)

Consider the possible scenarios a month from now in the final minutes of trading on the option expiration date:

Scenario 1: Bulldozers Inc. is trading at $102.

In this case, the $100 and $97 puts are both out of the money and will expire worthless.

The trader therefore gets to keep the full amount of the $600 net premium (less commissions).

A scenario where the stock trades above the strike price of the short put leg is the best possible scenario for a bull put spread.

Scenario 2: Bulldozers Inc. is trading at $98.

In this case, the $100 put is in the money by $2, while the $97 put is out of the money and therefore worthless.

The trader therefore has two choices: (a) close the short put leg at $2, or (b) buy the stock at $98 to fulfill the obligation arising from exercising the short put.

The former course of action is preferable, since the latter would incur additional commissions.

Closing the short put leg at $2 would entail an outlay of $600 (i.e. $2 x 3 contracts x 100 shares per contract). Since the trader received a net credit of $600 when initiating the bull put spread, the overall return is $0.

The trader therefore breaks even on the trade but is out of pocket to the extent of the commissions paid.

Scenario 3: Bulldozers Inc. is trading at $93.

In this case, the $100 put is in the money by $7, while the $97 put is in the money by $4.

The loss on this position is therefore: [($7 – $4) x 3 x 100] = $900.

But since the trader received $600 when initiating the bull put spread, the net loss = $600 – $900

= -$300 (plus commissions).

Calculations

To recap, these are the key calculations associated with a bull put spread:

Maximum loss = difference between strike prices of puts (i.e. strike price of short put less strike price of long put) – net premium or credit received + commissions paid

Maximum gain = net premium or credit received – commissions paid

The maximum loss occurs when the stock trades below the strike price of the long put. Conversely, the maximum gain occurs when the stock trades above the strike price of the short put.

Breakeven = strike price of the short put – net premium or credit received

In the previous example, the breakeven point is $100 – $2 = $98.

Advantages of a Bull Put Spread

  • Risk is limited to the difference between the strike prices of the short put and long put. This means that there is little risk of the position incurring large losses, as would be the case with puts written on a sliding stock or market.
  • The bull put spread takes advantage of time decay, which is a very potent factor in option strategy. Since most options either expire or go unexercised, the odds are on the side of a put writer or bull put spread originator.
  • The bull put spread can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the put strike prices are not very far apart, as this will reduce the maximum risk as well as the maximum potential gain of the position. An aggressive trader may prefer a wider spread to maximize gains even if it means a bigger loss should the stock decline.
  • Since it is a spread strategy, a bull put spread will have lower margin requirements compared to put writes.

Disadvantages of a Bull Put Spread

  • Gains are limited in this option strategy and may not be enough to justify the risk of loss if the strategy does not work out.
  • There is a significant risk of assignment on the short put leg before expiration, especially if the stock slides. This may result in the trader being forced to pay a price well above the current market price for a stock. This risk is greater if the difference is substantial between the strike prices of the short put and long put in the bull put spread.
  • As noted earlier, a bull put spread works best in markets trading sideways to marginally higher, which means that the range of optimal market conditions for this strategy is quite limited. If markets surge, the trader would be better off buying calls or using a bull call spread; if markets plunge, the bull put spread strategy will generally be unprofitable.

The Bottom Line

The bull put spread is a suitable option strategy for generating premium income or buying stocks at effective below-market prices. However, while this strategy has limited risk, its potential for gains is also limited, which may restrict its appeal to relatively sophisticated investors and traders.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker!
    Perfect Choice For Beginners and Middle-Level Traders!
    Free Demo Account! Free Education!

  • Binomo
    Binomo

    Honest broker!

Like this post? Please share to your friends:
Binary Options Trading Step By Step
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: