Lesson Objective: Understanding Bull Put (Credit) Spreads
| Category | Description | Example |
| Key Components | a) Short put
b) Long put with a lower strike |
1) Sell XYZ Jun 20xx $100 Put for $5
2) Buy XYZ Jun 20xx $95 Put for $2 |
| Why Use Bull Put Spreads? | The bull put credit spread gives the seller the opportunity of receiving some income upfront while limiting the overall risk. Both the premium received and the risk exposure are less significant than in the case of selling a naked put.
The risk/reward profile of the bull put spread is similar to that of the bull call spread even if you are receiving a net credit rather than paying a net debit upfront. Therefore, someone would typically use bull put spreads over bull call spreads if they prefer the idea of receiving a credit rather than paying a debit (again, in reality the risk/reward profile is very similar). A high historical implied volatility (of the underlying) would constitute another argument for selling puts as net option sellers usually have an edge (see lesson on Implied Volatility). An additional advantage compared to the bull call spread is that you would also make money if the underlying moves sideways since you received a net premium upfront. However, your maximum profit is limited to the premium received. |
Price of XYZ at $100
1) Sell XYZ Jun 20xx $100 Put for $5 2) Buy XYZ Jun 20xx $95 Put for $2 Net credit received: $3 = $5 – $2 |
| When to Use Bull Put Spreads (outlook)? | When you are moderately bullish on the underlying, hence the term “bull” put spread. If you were really bullish you would buy an outright call instead. You could also make some profit if the underlying moves sideways so this is a neutral to positive outlook type of strategy. | |
| Main Risks or Drawbacks of Using Bull Put Spreads | The main risk is for the underlying to decline below the breakeven price by expiration. You usually have a slightly wider risk than in the case of the bull call spread since your risk is not limited to a premium paid but rather to the width of the strikes of the spread minus the credit received. | |
| The Set Up | A bull put credit spread is a type of vertical spread. A vertical spread involves the purchase and the sale of puts (or calls) on the same underlying, with the same expiration but with different strikes. The term “vertical” comes from the position of the strike prices (typically one on top of the other) as can be seen on the screen of a broker’s platform.
In the present case, you will have to decide what strikes to select for each put, which warrants a trade-off between different parameters: (1) the premium you wish to receive upfront, (2) the maximum risk you are willing to take (i.e., the width of the strikes), and (3) the probability of success (i.e., probability of making any profit), which is usually provided on your broker’s platform. |
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| Net Credit or Net Debit? | As a net seller of options, this strategy is established for a net credit. | |
| Maximum Profit | Maximum profit equals the net premium received. It is reached if the price of the underlying is at or above the strike of the short put at expiration. | 1) Sell XYZ Jun 20xx $100 Put for $5
2) Buy XYZ Jun 20xx $95 Put for $2 Maximum profit of $3 ($5 – $2) per share if the price of XYZ is at or above $100 at expiration. |
| Breakeven Price | Strike of the short put minus net premium received | 1) Sell XYZ Jun 20xx $100 Put for $5
2) Buy XYZ Jun 20xx $95 Put for $2 Breakeven at $97 ($100 – $3). |
| Maximum Loss | The maximum loss equals the distance between the strike of the short put less the strike of the long put minus the net premium received. It is reached if the price of the underlying is below the strike of the long put at expiration. | 1) Sell XYZ Jun 20xx $100 Put for $5
2) Buy XYZ Jun 20xx $95 Put for $2 Maximum loss of $2 [($100 – $95) – $3] per share if the price of XYZ is at or below $95 at expiration. |
| Profit and Loss (P&L) Chart at Expiration | The P&L chart graphically represents the risk profile of a Bull Put Credit Spread strategy.
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1) Sell XYZ Jun 20xx $100 Put for $5
2) Buy XYZ Jun 20xx $95 Put for $2
Note: · The maximum profit of $3 ($5 – $2) if the price of XYZ is at or beyond $100 at expiration · The breakeven point at $97 · The maximum loss of $2 if the price of XYZ is at or below $95 at expiration · The risk/reward ratio: 0.67 or 2-to-3 ($2 max loss / $3 max profit) |
| Effect of Price Movements | The overall position will benefit if the underlying rises, moves sideways (around $100), or even slightly down as long as it stays above the breakeven price ($97) so, it has a slight net positive Delta.
On the other hand, if the underlying drops below the breakeven price of $97, the overall position will lose value at expiration. |
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| Effect of Time | The significance of time decay will depend upon the distance of the underlying from the strikes of the bull put spread.
Recall that long calls and long puts almost always carry negative Theta (because time only moves in one direction and the option holder has less and less time to be “right”) while short calls and short puts almost always carry positive Theta. If the underlying is above or near the strike of the short put, then the value of the spread depreciates (you make money) with the passing time because you hold a net short position and the (near-the-money) short put is eroded by the passing of time at a faster rate than the OTM long put (all else being equal) so, you would carry a net positive Theta. Conversely, if the underlying is below or near the strike of the long put, then the value of the spread appreciates (you lose money) with the passing of time because the (near-the-money) long put is eroded by the passing of time at a faster rate than the ITM short put (all else being equal), so you would carry a net negative Theta. If the underlying is somewhat equidistant to the strikes, then time decay has little effect on the overall value of the spread as the respective impact on the puts will offset each other. |
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| Effect of Volatility | Here again, the effect of implied volatility depends on where the underlying stands relative to the strikes of the spread.
Recall that long options have positive Vega while short options have negative Vega, and Vega is usually at its highest for ATM options because these options are more sensitive to changes in the volatility of the underlying. If the underlying is above or near the strike of the short put, then the spread will gain in value if implied volatility decreases because this will increase the value of the (near-the-money) short put faster than it will decrease the value of the OTM long put. Conversely, if the underlying is below or near the strike of the long put, then the spread will gain in value (you make money) if implied volatility increases because this will increase the value of the (near-the-money) long put faster than it will decrease the value of the ITM short put. If the underlying is somewhat equidistant to the strikes, then volatility has little effect on the overall value of the spread as the respective impact of the puts will offset each other. |
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| Assignment Risk | While the long put has no risk of early assignment, the short put does have such risk. | |
| Approval Level Required by Brokers | Usually, the trading of bull put spreads is authorized by brokers for most traders/investors since you have limited risk. However, this is a fairly complex strategy that require some proper risk management after the initial setup. | |
